Stock Market Crash

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At the Fool, it's no secret that we're big supporters of buy-and-hold investing. We approach the stock market with a long-term mentality, and hope that the stocks we buy produce excellent returns in our portfolio forever.

Even though buying and holding stocks over the long haul is a great investment strategy, sometimes the story has changed, and it’s time to sell. Your stock broker will have instructions on what you need to do to sell the stock. But you want to make sure that selling is the right move. Here's a list of 9 questions to help you determine when to sell.

  1. Do your original reasons for buying the stock still apply?
  2. Has the stock gotten overvalued?
  3. Do you need the money, or will you need it soon?
  4. Do you have the time to monitor the company's performance?
  5. Do you need to rebalance your portfolio?
  6. Did the company cut its dividend?
  7. Are there better opportunities to pursue?
  8. Was a takeover or merger recently announced?
  9. Is the company bankrupt?

Here's a closer look at each of these, and examples of valid reasons to sell.

1. Do your original reasons for buying the stock still apply?

When buying stocks, there are a few things to look for. Does the company produce consistent profits and sales growth? Is there an identifiable competitive advantage that will allow it to continue its growth for years to come? If something has changed fundamentally within the company or its industry since you bought the stock, it can be a good reason to sell.

As an example, let's say that you love a company because it's an industry leader and there isn't much competition to worry about. Blackberry about a decade ago is an example that immediately comes to mind. However, once other manufactures like Apple started to erode Blackberry's market share, it should have been a red flag that something had changed.

2. Has the stock gotten overvalued?

If a stock has become overvalued, it can be a good reason to sell, however there's an important point to keep in mind: This doesn't mean that you should sell your stocks just because the entire market has gone up, and things are looking a little expensive. Market ups and downs are part of long-term investing, and trying to time the market rarely works out.

Instead, ask yourself whether a company's valuation is justified by its profits and growth. If your stock is trading at 20 times earnings while its peers are at 15 times earnings with similar growth metrics, this is the type of overvaluation I'm referring to. In a situation like this, it's worth looking into whether or not you'd be better off putting that capital to work by purchasing a more reasonably priced alternative.

3. Do you need the money, or will you need it soon?

Stocks are great investments, if you have a long time horizon. However, over shorter periods of time (say, five years or less), markets can fluctuate significantly. Even Warren Buffett discourages investors from buying Berkshire Hathaway shares unless they have years to let their investment grow.

So, if you will need the money from your investments within the next several years to cover expenses, send your kids to college, or for any other reason, it can be a good idea to unload some of your stocks and focus on preserving your capital instead.

4. Do you have the time to monitor the company's performance?

Buying stocks is a time-consuming activity, if it's done correctly. Not only do you need to dedicate some time to do research before you buy, but it's important to spend some time periodically to keep up with how the company is doing in order to make sure the investment is still suitable for your objectives. If you don't have the time to do that, it may be a good idea to focus on low-maintenance investments like index funds and ETFs instead.

5. Do you need to rebalance your portfolio?

Rebalancing refers to a periodic adjustment to your portfolio in order to maintain a certain allocation to each of your investments. This can be especially important if one of your stocks has performed exceptionally well recently.

I know what you're thinking: There's no such thing as a stock you own going up too much. And, to some extent, that's true. However, the problem when one of your stocks performs extremely well is that your portfolio becomes a little too reliant on the performance of that one stock. It's important to be aware of how much of your portfolio (percentage-wise) is invested in each of your stocks, and to rebalance your holdings if it gets out of whack.

6. Did the company cut its dividend?

A dividend cut is often a sign of trouble at a company, no matter how its PR team decides to spin it. This is especially true if a company has a strong track record of dividend growth. That's not to say that a dividend cut is a reason to abandon a stock all by itself, but it's definitely good cause to take a closer look. If a company cuts its dividend, there are a few things to check, including but not necessarily limited to:

  • Are profits and/or margins shrinking?
  • Is the company's growth rate slowing, either due to competitors or a maturing business?
  • Is the company's debt load getting out of hand?
  • Or, is there a legitimate reason for the dividend cut? For example, if a company cuts its dividend but increases its buyback program by the same amount, in order to take advantage of a low stock price, it could actually be the right move for shareholders.

7. Are there better opportunities to pursue?

This is best explained by an example. I'm a fan of healthcare real estate as an investment, and own Welltower in my retirement account. Early in 2016, some seemingly bad news came out about HCP, another healthcare REIT, that pushed its stock price down to an extremely cheap level. In order to take advantage of the opportunity this created, without putting too much of my money in healthcare real estate companies, I sold some of my Welltower shares to buy some HCP.

8. Was a takeover or merger recently announced or completed?

If one of your stocks agrees to be acquired, the share price will typically rise rapidly to the level of the takeover offer, or close to it. While this is great in the sense that it's a quick profit, there's no real hope of further gains, at least until the deal closes. LinkedIn is a good current example of this. Since its takeover by Microsoft was announced, LinkedIn hasn't moved a whole lot after its initial pop – and investors may be better off taking their profits and deploying that capital in another stock with growth potential.

As far as a completed merger goes, Berkshire Hathaway's actions after the recent AT&T/DirecTV merger is an excellent case study. Berkshire Hathaway had accumulated a large DirecTV stake because the company dominated its business and had lots of growth potential, especially internationally. However, after the merger, Berkshire was left with a large position in AT&T -- a great company, but not a market-dominating company with high growth potential. So, Berkshire unloaded its position shortly after the deal was finalized.

9. Is the company bankrupt?

If a company declares bankruptcy, it's a virtual certainty that its shares will be worthless once the bankruptcy proceedings are completed. Even if the stock is trading for pennies per share, it's usually a good idea to sell immediately after the bankruptcy announcement in order to salvage what you can, and lock in a loss you can use to reduce your taxes.

When not to sell a stock

Notice that there's no reason on the list having to do with the stock's price dropping. That's because if your stocks drop because of a market correction or general sector weakness, it's a terrible reason to sell.

Depending on the report, average investors produce returns of approximately 3% per year, even though the market's historical returns have averaged more than three times that amount. This is mainly because when markets crash and stocks drop, many investors panic and sell. And, when stocks keep going up and up and they see everyone else is making money, they buy.

It's common knowledge that the point of investing is to buy low and sell high, but selling because your stocks went down is the exact opposite of that. Of course, if your stocks go down because of any of the reasons listed here, such as a fundamental change in the business, by all means go ahead and sell. However, if the price drop has little to do with the company itself, a price drop should be looked at as a buying opportunity, not a reason to panic.

Selling a stock vs. shorting a stock

Finally, it's worth mentioning the difference between selling a stock and shorting a stock. When we say "selling", we're referring to disposing of shares that you actually own. Shorting, on the other hand, is the act of selling a stock that you don't own, hoping to buy it back cheaper when the price drops.

The selling reasons we discussed earlier can also be reasons for short-selling, but it's important to point out that short-selling is an inherently risky form of stock trading. When you buy a stock, the amount you can lose is limited to the amount you spent for the shares, plus commissions. For example, if you buy $2,000 worth of a company's stock, that's the most you can lose, even if the stock goes to zero.

On the other hand, shorting a stock has unlimited potential for losses. Let's say that a certain stock has been plunging because of bankruptcy rumors and is now at $2 per share, so you decide to sell 1,000 shares short, convinced it is heading to zero. Well, if news that the company avoided bankruptcy comes out and the stock rockets to say, $10, you'll be in the red by $8,000. If the stock continues to climb, there's no cap to your downside.

Therefore, short-selling is best left to experienced traders who know exactly what they're getting into.

The Foolish bottom line

There are plenty of valid reasons to sell stock, and even the most long-term oriented investors sell stocks from time to time for one reason or another. Warren Buffett once said "our favorite holding period is forever," and it's a great rule to live by. It's a great idea to go into every investment with the intention of keeping the stock forever, but that doesn't mean you necessarily will.

This article was written by Matt Frankel, who owns shares of Apple, Berkshire Hathaway (B shares), AT&T, Welltower, and HCP. The Motley Fool owns shares of and recommends Apple and Berkshire Hathaway (B shares). The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Welltower. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.