How To Know When It’s Time To Sell Your Stocks

How To Know When It’s Time To Sell Your Stocks
Theodora Lee Joseph, CFA

11 months ago6 mins

  • Having a clear sell strategy, even before you buy, can benefit you in the long run by ensuring your emotions don’t get in the way of your investment objectives.

  • There are five “sell” rules professional fund managers think about when divesting a stock: company fundamentals, valuation, stop-losses, the investment thesis, and alternative opportunities.

  • The ideal holding period is, as Warren Buffett says, “forever”, alas, great companies don’t always stay great, so knowing when to sell is just as important as knowing when and what to buy.

Having a clear sell strategy, even before you buy, can benefit you in the long run by ensuring your emotions don’t get in the way of your investment objectives.

There are five “sell” rules professional fund managers think about when divesting a stock: company fundamentals, valuation, stop-losses, the investment thesis, and alternative opportunities.

The ideal holding period is, as Warren Buffett says, “forever”, alas, great companies don’t always stay great, so knowing when to sell is just as important as knowing when and what to buy.

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Identifying and investing in good companies isn’t simple, but it’s a lot easier than knowing when to sell them. Having a clear sell strategy, even before you buy, can benefit you in the long run by ensuring that your emotions don’t get in the way of your investment objectives. Here are five “sell” rules that professional fund managers lean on to guide their exit strategy.

How do you set some sell rules for stocks?

When markets go south, it can be tempting to sell immediately to prevent losing more. And when they’re on an upward trajectory, you might be tempted to hold onto your winners for far too long. But in reality, how you expect markets to move shouldn’t impact most of your decisions on when to buy or sell. That’s why you should work on developing your own sell discipline, based on your investment objectives.

1. Worsening company fundamentals

When a company sends out a profit warning – that is, signaling it’s going to disappoint majorly compared to previous guidance or analyst expectations – that’s usually the first sign of more trouble. In fact, many fund managers will sell their positions immediately upon a profit warning, even if the share price is sharply down on the day. It’s also worse if the company’s profit warning is an isolated incident in its industry.

Keep in mind that, historically, a company that profit-warns once will usually do it a second time, and possibly a third. And things rarely go from good to bad in a single quarter, so it’s wise to examine whether the reason you bought shares in the company in the first place is still valid: if not, the wisest decision sometimes is to realize a quick loss by selling your position.

2. Fair valuation

Selling a winning stock is hard. After all, it’s easy to assume the stock that’s driven returns in your portfolio in the past will continue to do so for the next decade. But the truth is, you’ll be better off evaluating the upside potential versus downside potential of the stock on a fresh basis. This is where valuation comes in. It’s important to compare the stock’s price-to-earnings (P/E) ratio to that of its history, and also relative to its peer group. If the stock’s P/E ratio is high relative to its peers and its own history, it’s worth questioning if that premium is justified. On the other hand, if you think the improvement in growth or earnings quality can justify a further multiples expansion, then holding onto the stock for longer isn’t necessarily a bad idea.

A word of caution though, holding onto a stock purely for multiple expansion opportunities tends to be one of the lowest-quality reasons to own a stock. Valuation is part art and part math, so it’s important to avoid relying on only one type of valuation methodology or a single historical period when evaluating. Instead, try a range and mix of different valuation methodologies to see if the results say the same thing.

3. Stop-losses

If you’re time starved and don’t have capacity to examine each of your stock holdings, it may be worth considering technical rules instead. The simple 2% rule can ensure that no single position will lose you more than 2% of your portfolio. This allows you to keep track of how much money you have in each stock, and the maximum losses you can afford to lose in one position in order to cap the maximum loss at 2%. Now, that 2% figure is arbitrary, and you can increase or decrease it according to your risk appetite. But remember that selling losers in your portfolio can be hard, so having a strict stop-loss in place, which will automatically hit the “sell” button at a price you choose ahead of time, can go a long way in removing the emotional aspect from your decision-making.

When it comes to selling your winners, a popular rule that works for lower-priced small-cap stocks is to sell half of your position when the stock doubles. This way, you can take your initial investment off the table, so anything else from your remaining position is pure profit.

4. When the thesis changes

If you own a stock, you ought to know why you own it and its purpose in your portfolio. You don’t sell stocks only when they do well. Many times, a stock can do well and still be within your price target, but give you cause to sell. For example, you might own McDonald’s because you think the company has a solid brand, access to low-cost, high-quality ingredients and is able to grow faster than peers, and thus steal market share. However, if over time the company has outgrown its peers, but has done so only through acquiring other brands and franchising its own – it’s probably worth examining if your thesis on the company has changed, and if so, whether you’re comfortable still owning it.

5. Better opportunities arise

Good ideas are hard to come by, so when better opportunities arise, that can be a good reason to sell the stocks that once served you well. Problem is, selling your existing positions can be difficult, especially if they’ve done you well. They’re just stocks, but we do grow emotionally attached to the things we invest in. That’s why it’s a good idea to build up a cash cushion. There may be many buying opportunities, but the best ones tend to be driven by the things a company can actually control. A company that’s expected to do well because of a new product is a better investing opportunity than a company that’s expected to do similarly well because of an expected improvement in the macro environment.

So what can you take from all that?

As Warren Buffett would say: “our favorite holding period is forever”. But, then, things don’t always work out perfectly and even the best investor makes mistakes (as Buffett did with Tesco). So working out your sell limits – even before you purchase a stock – is a great way of instilling discipline in your investing and removing emotions from your decision-making. While trading as infrequently as possible is not only tax efficient, but also time efficient (especially if you’re a long-term investor), it’s worth remembering that great companies don’t always stay great. Knowing when to sell is just as important as knowing when to buy (and what price to pay).

Building a core portfolio of passive market ETFs can reduce your need to think about which stocks to divest. Over time, as you build a satellite of active positions around your core positions, you will need to be critical and intentional about your entry and exit points.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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