Be Smart About Taking Profits

It's probably happened to you: You buy a stock, and it goes up. You hold on, hoping that it will become the next home run for your portfolio. But then the price drops back, and suddenly you want to beat yourself up for not grabbing your profits when you had the chance.

In many ways, deciding when to take some profits off the table is a harder question than figuring out when to sell your whole position. When you find negative things about a particular stock -- bad managers, a cloudy financial forecast, or the loss of its competitive advantage -- it's not hard to say adios to the stock entirely without a second thought.

Taking profits, on the other hand, isn't that simple. You don't necessarily want to give up entirely on a stock -- you may just want to lock in your gains at an opportune moment.

Cutting your winners
The biggest problem with taking profits on a stock is that you miss out on any future growth in the shares. During the 1990s, for example, early investors in Microsoft (Nasdaq: MSFT  ) and Dell (Nasdaq: DELL  ) had ample opportunity to cash in after seeing their original investment double or triple. Yet if investors took profits after those gains, they gave up the much larger returns that ensued by the end of the decade. More recently, PotashCorp (NYSE: POT  ) tripled between 2003 and 2005, but has since gone up another 600%.

The other side of the coin, of course, is that taking profits reduces your losses if the market turns downward. Those who held Yahoo! (Nasdaq: YHOO  ) or Sun Microsystems (Nasdaq: JAVA  ) in the late 1990s enjoyed huge paper gains -- but if they held onto all their shares, most of those gains evaporated by the time the bear market ended 2002.

When it pays to take profits
Unfortunately, you'd have to have perfect foresight to know when taking profits would make the most sense. But you don't have to be able to time the market to make taking profits a smart move for your own particular financial situation. Here are a few situations where you may want to consider grabbing some gains:

  • When your portfolio gets too concentrated. If you ride a stock long enough, it can come to dominate your portfolio. For instance, when shares of Time Warner's (NYSE: TWX  ) America Online and Iomega made up nearly half of Fool co-founder David Gardner's Rule Breaker portfolio in 1997, he pared down his positions, cutting the concentration down to about a quarter.
  • When a better idea comes along. If you're fully invested, buying a new stock means having to sell something you own. Paring down a position can help fund your new investing ideas, and hopefully, your new stock will do even better than your existing holding. Continuing the Foolish example, that's what David did with some of the proceeds from his sales of AOL and Iomega -- he bought (Nasdaq: AMZN  ) , which proved to have more profit potential.
  • For tax purposes. Usually, hanging onto shares is the best way to avoid taxes -- you don't have to pay tax on gains until you sell. But if you're temporarily in a low tax bracket, or you think income tax rates will rise, taking some profits lets you realize gains now at your current low rate. That can save you taxes over the long run.
  • When you need the money. Your personal finances include much more than just your stock investments. If you anticipate needing money for other parts of your financial life, such as a down payment on a house or just keeping up with bills, selling shares high when the opportunity comes can be a great move.

As with any other investment decision, it's best to take profits only when you're thinking rationally and unemotionally. Taking profits for their own sake rarely makes sense. But if you want to maintain a diversified portfolio or invest in something that you think has more potential, then trimming your winners can help keep you going in the right direction.

Learn more about basic investing: is a Motley Fool Stock Advisor recommendation. Learn more from the Gardner brothers about picking great stocks -- and getting rid of them when they don't work out -- by taking advantage of our 30-day free trial offer.

Fool contributor Dan Caplinger has been known to take some profits from time to time. He doesn't own shares of the companies mentioned in this article. Microsoft and Dell are Motley Fool Inside Value picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy wants to make you profitable.

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