I don't believe in buy and hold until death do you part. The way I see it, the choices you can make are to buy, hold, or sell. It seems crazy to forgo one of your three options simply to adhere to a motto. Flexibility is one of your biggest advantages as an investor. Why give it away for nothing?
By the same token, if you sell too quickly, you can miss out on huge multibaggers such as Hansen Natural (Nasdaq: HANS ) . I didn't buy that stock when I first looked at it at $2 (split-adjusted) back in 2004. And while I feel bad I didn't, I probably feel better about it than the people who bought at $2 and sold at $3 for a quick 50% profit.
Really, you want the best of both worlds -- a strategy that allows you to both harvest profits and achieve huge returns. That means thinking carefully about both your sell criteria and your hold criteria. These criteria are different for every investor and every portfolio, but I've found the following works well for me.
Hold when: The price changes
Price changes, up or down, don't change a company's fundamentals. If you sell simply because the stock's made you 50% in a short time, you're potentially throwing away a much bigger long-term profit. If the price goes down on no news, the company becomes more attractive, not less. So, it doesn't make sense to sell simply based on price changes.
Before the last presidential election, health insurers were quite cheap. Investors were concerned about the potential of a Democratic administration changing the operating environment for health insurers. Humana (NYSE: HUM ) and Cigna (NYSE: CI ) both took hits that November. Investors who sold based on the falling prices missed out on some extraordinary gains since then.
Hold when:Temporary bad news comes
Bad news will come to every stock, sooner or later. The company will miss estimates by pennies but fall by dollars. In itself, this isn't a reason to sell. If the factors are temporary, and, in the long term the business is still strong, it still makes sense to hold, or even buy.
For example, I bought specialty auto insurer Kingsway Financial (NYSE: KFS ) in 2003 at $11.40. Mere days later, the company announced a reserve adjustment, which pushed the shares down to $9. It was unfortunate timing, but it didn't seem to affect the company's long-term potential, so I bought more. Now the stock is trading for a little less than $20.
Sell when:The stock's way overvalued
If a great stock's fairly valued, then it generally makes sense to not sell it. You'll likely know that company better than any new company you add to your portfolio, and it's hard to find great companies at cheap prices, so you should naturally be reluctant to give up the ones you have. But if the company becomes extremely overpriced, then it's time to jettison it -- it will be unlikely to earn spectacular future returns.
A couple years ago, Warren Buffett noted that he made a mistake holding on to Coca-Cola (NYSE: KO ) through its highs in the late 1990s. Though Coke's a great company, it was way too expensive back then, and subsequently, its stock has had terrible returns.
Sell when: The business changes
If you're buying a great business, and suddenly you notice that the business isn't actually that great any more, it can make sense to sell. The key decision point is whether the changes are temporary bumps or the company's business is weakening. I suspect Berkshire Hathaway has been selling H&R Block (NYSE: HRB ) recently for such a reason.
The customer base and the margins of its core tax-return business are slowly being eroded by competition from tax software such as Intuit's (Nasdaq: INTU ) TurboTax. H&R Block has responded with its own tax software, but it's clear that technology is changing the tax business and weakening H&R Block's competitive position.
Sell when:There's a better stock to buy
If you're short on money but see an incredibly compelling stock that you absolutely must own, then by all means sell a less attractive stock to raise funds. But before you make the switch, make sure that you take into account transaction costs and taxes. Often it won't make sense to sell a company in which you have large returns, pay the taxes, and put the proceeds into a marginally more attractive stock.
The Foolish bottom line
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Fool contributor Richard Gibbons wonders what's up with the snow in South Africa. He owns shares of H&R Block and Kingsway but does not have a position in any other security discussed in this article. Coke and Intuit are Inside Value recommendations. The Fool has a disclosure policy.