Don't Sell That Stock!

One of the biggest challenges in investing is deciding when to sell stocks out of your portfolio. But did you know that you're probably selling stocks without even realizing it?

When not buying is selling
At last year's annual meeting, Chris Davis, manager of the Clipper Fund (CFIMX), argued that mutual funds essentially sell some of their holdings in a company when they choose not to buy more, and instead add a different holding to the portfolio.

He used Warren Buffett's Berkshire Hathaway (NYSE:BRK-B) as an example, saying, "Every year that they didn't buy Coca-Cola, they sold Coca-Cola. Coke became a smaller percentage of their assets as new money came in and didn't go into Coke."

In other words, as new money comes in and is allocated to new positions, old positions have a smaller and smaller share of the investment pie. So the influence an old position can have on returns gets smaller and smaller, just as if some of that position had been sold.

If you've ever added new money to your portfolio by buying new holdings, the same thing has happened to you.

The big picture
Although we tend to talk about stocks one by one, the way they're combined in your portfolio is an equally important part of investing. It's not enough to just add stocks to your portfolio whenever you run across compelling investments. You also need to account for your overall diversification, and the size of the various stakes within your portfolio.

Fail to pay attention to the overall makeup of your portfolio, and you might end up with a large chunk of your holdings in, say, oil-related companies or pharmaceutical companies. If the price of oil plunges, or health-care reform includes draconian price controls on medicine, those companies could all take a big hit.

But you don't want your portfolio to get too complex, either. If you've added so many companies that each one makes up just 1% or 2% of your portfolio, a big home run from one stock isn't likely to make a huge difference in your bottom line.

That's why, as Davis suggested, adding more money and companies to your portfolio, and therefore shrinking the power of your existing holdings, matters.

Perfect your portfolio
Instead of distributing your dollars among the stocks that seem most promising, the 56th-most-promising stock, and all the stocks in between, you want to concentrate your investments on your very best ideas -- even when you add money.

Advisors often recommend holding between eight and 12 (sometimes as many as 20) companies in your portfolio. And that means making sure that every investment really is one of your very best ideas.

What constitutes a very best idea? For my part, it means stocks with strong prospects and strong growth. Stocks with solid dividend yields are a plus, too, and those with low P/E ratios can be bargains. Screening is a good way to unearth candidates for further research. For example, here are some companies that popped up when I screened at Motley Fool CAPS for companies rated four or five stars (out of five), with three-year revenue and earnings growth rates of at least 10%, and returns on equity (ROE) of at least 15%:

Data: CAPS.Fool.com.

The Foolish bottom line
You should always be putting your money into your very best ideas. If a new idea supersedes an old one, selling a less-good idea to put that money into the very best idea is the right move. But whatever you do, don't sell your stocks without knowing it.

If you'd rather not hunt for promising companies on your own, let us help you. I invite you to check out our Motley Fool Inside Value newsletter, which seeks out undervalued companies to hold for the long term. A free, no-obligation trial will give you full access to all past issues and all recommended stocks. Just click here to get started -- there's no obligation to subscribe.

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This article was originally published on June 1, 2009. It has been updated.

Longtime Fool contributor Selena Maranjian owns shares of Berkshire Hathaway and Coca-Cola. Berkshire Hathaway is a Stock Advisor recommendation. Berkshire Hathaway and Coca-Cola are Inside Value recommendations. Coca-Cola is an Income Investor pick. The Fool owns shares of Berkshire Hathaway. The Motley Fool is Fools writing for Fools.