"Take care to sell your horse before he dies. The art of life is passing losses on."
-- Robert Frost
By now you've probably heard, from us and from others, that selling after a big market meltdown often isn't the best idea. Legendary investor Warren Buffett instead advises us to "Be fearful when others are greedy, and be greedy when others are fearful."
If selling because your stocks have tanked isn't smart, when exactly should you consider selling? Here are some suggestions.
Remember that investing successfully boils down to value. You want to buy stocks that you believe the market is mispricing. It can be tricky to nail down their estimated value, but very high valuation ratios -- price-to-earnings, price-to-book, price-to-sales -- are one red flag warranting a closer look.
Consider Corning (NYSE: GLW ) . In 2000, before the dot-com crash, Corning sported an average P/E ratio of 178, an average P/S ratio of 6.7, and an average P/B ratio of 4.6. More recently, those numbers were 6.0, 2.5, and 1.1, respectively. In retrospect, Corning sure seems to have gotten ahead of itself in 2000 (though it was hardly the only one).
When valuations run high -- compared to the company's historical rate or industry peers -- your margin of safety shrinks or disappears, and shares have a higher likelihood of retreating closer to their intrinsic values. Beware of overvalued holdings in your portfolio.
Make reasoned investing decisions based on research and deliberation, and stay aware of their own counterproductive tendencies. The field of behavioral economics has pointed out shortcomings such as the "house-money effect," documented in a 2003 Federal Reserve Board of Atlanta working paper, which makes us more likely to take ill-advised chances with money when we don't think of it as truly our own. If you double or triple your money on a stock, you'll be more likely to put some of that moola into extra-risky investments than if you were coming to them with money you earned from work. Remember: Money is money! You should be prudent with all of it. If you've bought some risky highfliers on a whim, you're speculating, not investing -- and you may want to sell them.
Next, think about how much you know about your holdings. If you can't explain exactly what they do, and how they make their money, then you should either learn more or sell. Being clueless leaves you vulnerable to nasty surprises. If you're a Monsanto (NYSE: MON ) investor, for example, are you reasonably well-versed in agriculture, crop nutrients, seeds, and pest control? If you invest in Baidu (Nasdaq: BIDU ) , are you familiar with the economic conditions in China, and with the key players in the online search business there? If you're simply not interested in a company or industry, you'd do well to steer clear; if it puts you to sleep, you're probably not going to want to keep up with its developments.
4. Worrisome trends
Watch for ominous signs in your company's financial statements. Sliding sales or earnings, or a number of items growing at a much faster clip than sales -- such as accounts receivable, inventories, or debt -- can provide early warnings of bigger trouble ahead. Between the fiscal years ending in February 2007 and February 2008, Target's (NYSE: TGT ) revenue rose 6.5%, while accounts receivable rose 30%. That's the kind of trend worth looking at more closely. A look at FedEx's (NYSE: FDX ) numbers shows that despite an improvement in its performance in recent years, the past year -- an admittedly bad one -- has registered drops in net profit margin, return on equity, and return on assets.
5. Investment thesis changed
If the reason you bought in the first place is no longer valid, it may be time to sell. Suppose you invested in America Online because of its status as a major service provider in the burgeoning online world. Your investment thesis likely changed when it melded with Time Warner (NYSE: TWX ) , since the new entity encompassed many different kinds of businesses, from magazines to movies to cable television. And while it's possible that you liked the new company more, you should still have recognized that the deal altered your investment thesis, requiring you to take a second look.
Similarly, if you bought into Home Depot (NYSE: HD ) a few years ago because you expected great things of new CEO Bob Nardelli, you might have thought twice after learning about the company's now-infamous annual shareholder meeting in 2006. The executives took no questions from attendees, no directors attended, and no votes were counted. Nardelli only showed up for 30 minutes.
6. Short-term money
The final sell consideration has less to do with the quality of a company, and more to do with your individual circumstances. This might be a shocking suggestion, but you might want to do a lot of selling if you'll need the money soon, or at least within a few years. (Five years is a good cutoff, but it could be as much as 10 years, if you want to be extra-conservative.) Such short-term money should not be in stocks because ... well, because 2008 can happen now and then, knocking stocks down 40%. Keep your short-term money in CDs, money market funds, or other "safer" places.
Putting it all together
Now that you've got all this under your belt, you might be feeling a little stressed out. Don't. Investing can be as simple as regularly adding money to a broad-market index fund, and not giving it much more thought than that. But if you want to aim for higher returns, you'll need to carefully select a basket of individual stocks and/or mutual funds -- and monitor when to add to those holdings, and when to sell them. We'd love to help you with that part, absolutely free.
Our Motley Fool Stock Advisor service, led by Fool co-founders David and Tom Gardner offers two picks each month -- one from Dave's growth-intensive approach to investing, and the other from Tom's methodical, small-cap value approach. On average, their recommendations are beating the S&P 500 by more than 25 percentage points.
Try Stock Advisor free for 30 days. You'll get full access to all past issues and recommendations, including a number of great stocks that have become part of my own portfolio. Here's to selling stocks that won't serve you well -- and buying more promising ones!
Longtime Fool contributor Selena Maranjian owns shares of Home Depot and Time Warner. Home Depot is a Motley Fool Inside Value selection. Baidu is a Motley Fool Rule Breakers pick. FedEx is a Motley Fool Stock Advisor recommendation. The Motley Fool is Fools writing for Fools.