For many investors, determining when to sell is a difficult task. Here's a way we can think about selling:
The best stock to sell right now is the one that no longer meets our investment objectives.
As investors, we should have goals for each of the stocks we own. Well, when those stocks have either achieved their goals or it has become evident that they won't achieve those goals, it's time to sell.
But let's not make it more difficult than it already is. Remember, when we sell something, we're also buying something -- it's simply a trade. Each trade has trade-offs. We need cash to buy stock, and when we sell stock, we are, in a sense, buying cash. But the decision should revolve around meeting our investment objectives, and it should be based on future expectations rather than past events. What has already occurred is a sunk cost (or gain). In other words, we're interested in how to meet our future planned objectives.
The difficult part is that there are no hard and fast rules for these decisions; every investor has different objectives. Some investors want dividends; others prefer capital gains. Some investors buy on fundamentals; others trade on momentum. Regardless, when it comes to investment goals, each trade should have a set objective that fits within the overall investment plan.
Typical selling situations
There are some "sell versus hold" guidelines to help us along the way. Here are some of the situations that we often face when it comes to deciding whether to sell a stock:
- A stock has risen more than expected and is overvalued. This would be a sell.
- A stock hasn't met our expectations, and there's no evident catalyst present to meet those expectations. This would also be a sell.
- New information comes to light. This requires us to do further analysis and could be a buy, sell, or hold.
- A stock has risen more than expected but is not overvalued. This is by far the best situation and a hold.
- A stock hasn't risen, but we still believe there's a catalyst that could unlock some of the stock's perceived value. This is probably the most challenging of the list, but is most likely a hold.
Consider an investor who had the fortune to purchase Google (Nasdaq: GOOG ) in 2004 for $100. Let's consider Jane. While Jane would be sitting on an outstanding gain to date, the decision whether to continue to hold Google should be based on how it will fare over the appropriate future time horizon. If her goals are to achieve a 12% compounded return and she believes that $500 represents a fair price for Google and discounts Google's cash flows at 12%, then Google should continue to meet her investment objectives. However, if Jane believes that Google's value is really $400, then the current market price already discounts the future growth and selling should be considered.
Now what if Jane chose to purchase Yahoo! (Nasdaq: YHOO ) instead of Google back in 2004 for $24? At a recent quote of $27, Yahoo would not have met her 12% compounded return goal. While the poor performance should be evaluated, if she thinks that Yahoo! is currently worth $40 based on a 12% discount rate, then she should continue to hold. But if three years have passed and the future outlook hasn't changed, then it's clear that the original investment thesis hasn't panned out, and Jane should consider a trade.
Obviously, these examples are oversimplifications; when executing a trade we must consider a multitude of factors, including the stock's volatility, the amount of stock involved, as well as the tax implications of selling. As a Foolish investor, I'm also assuming we're investing in a business based on fundamentals. But the point should be clear, regardless of how well or poorly a stock has done in the past -- if it isn't likely to meet our investment goals moving forward, then it should be sold.
Half the handshake
And the question of whether Google or Yahoo! is sold is only part of the trade. The cash received, which will currently earn 4% in a money market account, won't achieve our 12% compounded growth rate, either. So there's the trade-off of holding cash -- less risk of losing money, but increased risk of not meeting your goals.
To complete the handshake, we must be on the lookout for new opportunities that can achieve our goals when our existing trades will not. There are plenty of places on Fool.com to get ideas, from our CAPS service to idea articles like "The Best Stocks Right Now" or "A Fool's Guide to Multibaggers."
I hope it's clear that making a sell decision, while tough, is really making another buy decision. What often muddles our decision-making is what behavioral finance calls the disposition effect. When we sell a stock, we confirm the quality of the original decision. That's why, more often than not, we tend to sell our winners too early (seeking pride) while holding on to our losers too long (fear of regret). It would be easier to sell Google, confirming one's stock-picking prowess, and by not selling Yahoo!, we could avoid confirmation of a poor decision.
However, if we want to make the appropriate sell decisions for our portfolios and not our egos, we need to be aware of these types of psychological factors than influence our decision-making. And the best way to avoid these pitfalls is to have an objective for each trade that is consistent and measurable with the overall investment objectives.
So while selling is tough, it's really no harder than buying. And both are just means to the same end -- our investment goals.
For related Foolishness:
Yahoo! is a Motley Fool Stock Advisor pick.