An interesting question recently came up on Pencils Palace, my discussion board on The Motley Fool, regarding when it is appropriate to sell a stock. This particular user owned a stock that had increased more than 500%, leading this one stock to make up 30% of his portfolio. While there are a variety of opinions on when (if at all) to sell a portion of a winning investment, my perspective on this issue has evolved based on personal experience.
It's natural for investors to get nervous after a stock has quickly increased in value and become a major position in one's portfolio. When a business does exceptionally well, our instincts tell us to sell the high-rising stocks and shovel the proceeds into something else. This line of thinking is what led me in the past two years to sell a portion of my Netflix (NASDAQ: NFLX ) position at $245 and most of my Chipotle Mexican Grill (NYSE: CMG ) position at about $300.
Netflix has managed to quadruple its subscriber base to more than 40 million subscribers since 2009, pushing the company to be the best-performing stock in the S&P 500 (increasing 298% in 2013). Chipotle has increased its restaurant base more than 50% to over 1,500 restaurants since 2009, and the stock has risen 800% over that time period. Netflix and Chipotle both benefit from innovative and visionary founders who remain as CEOs today -- Reed Hastings and Steve Ells, respectively. Both Hastings and Ells are determined to revolutionize their respective fields over the long haul. Netflix is transforming the delivery of entertainment (first with DVD-by-mail and now with online streaming), while Chipotle is raising the bar for quality, speed, and service in the "fast casual" arena.
Both Netflix and Chipotle continue to expand their reach and have proven themselves to be innovative leaders within their respective fields. Yet when I saw my investments reach gains of more than 500%, I sold the majority of my position in each company despite no significant change in the long-term prospects of the businesses. Netflix shares are now above $360 apiece, and Chipotle stock is going for about $525. Whoops.
Focus on the fundamentals
Ask yourself: Are there companies that offer brighter prospects and more potential than my current winning investment?
Looking back on some of my investing decisions, many times I sold portions of quality businesses -- my best investments -- only to invest in businesses that did not offer near the potential. Yet business fundamentals and prospects, not stock prices, should be the primary consideration in our investing decisions. This goes for buying or selling.
Have the business' fundamentals and prospects dramatically shifted since you first invested? Is there any reason to think the long-term potential of the business has diminished? If the answer to either of those questions is yes, then it may be a good idea to sell a portion of the investment.
If, on the other hand, the company remains a quality business with a promising future, then there's good reason for the stock to make up a hefty chunk of your portfolio. If the fundamentals remain intact and the company's future looks bright, you might be hard-pressed to find a better place for your investing dollars.
Don't punish your winners
Remember what Peter Lynch, famed Fidelity Magellan fund manager, said: "All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don't work out."
We want our investments to go up. Curious, then, that we sometimes get it in our heads that we should sell our winners and pump the money into our lagging investments.
Think of it this way: Hopefully, at some point, all of your investments will be multibaggers. The fact that one got there sooner than the others shouldn't be the only basis of trimming your position.
This is a great problem to have as an investor. In hindsight, I would have been far wiser to keep (or even buy more of) my winners rather than selling and adding to other companies. Here's another great quote from Peter Lynch to remember: "Know what you own, and know why you own it."
Foolish bottom line
If you can't sleep at night because a large chunk of your portfolio is in one stock that has done exceedingly well, that may be a good reason to take some gains. However, if you remain confident in the business' long-term prospects, then why cut your holding's profitable run-up short?
As investors, we should hope to face many more of these "dilemmas"!