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Buy and Hold, But Don't Forget to Sell

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By ChrisMcAdams
June 27, 2002

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Buy and Hold, But Don't Forget to Sell

Or What I've Learned about Investing

When I first started investing, I was sold on the Long-Term, Buy and Hold principle. That is, you buy stock in a good company and hold it for decades. The advantages have been well argued on these boards and at the Fool's School, and for the most part, I agree with them:

1. You avoid the cost of commissions by reducing the number of transactions.
2. You avoid the tax consequences of a capital gain.
3. You don't get obsessed with market timing. I see this as the biggest benefit for me. I've got work to do and don't have time to look at stock quotes all day.

The biggest problem with Long-Term Buy and Hold is the name. It's conspicuously missing the other half of investing�Selling your stocks. Now some people will argue that you may never sell a good stock. But it seems that the whole point of investing is to maximize the value of your capital so that at some point you have the option to use that capital for something else, right?

Taking Your Profits: So, If you buy stock in a company and see the valuation of that stock climb to ridiculous levels, would it not be prudent to sell the stock? I'm not talking about 20 or 30% overvaluation. That level of overvaluation is hard to detect at all, much less make a sell determination on.

What I'm talking about is the ridiculous valuations that we saw over the past few years and are now, if we held, paying the penalty for. For example, JDSU was valued at 250 times pro forma earnings in 2000. Perhaps, if you apply Wish-Fulfillment Discounted-Cash-Flow Analysis to the anticipated earnings, then you might be able to justify the enormous price, sort of, and only if you already own it. But if it takes assumptions that smell a little fishy, should you think about selling and waiting for the price to come in line with the actual value?

The argument I heard all during 2000 about JDSU was that it was the next Intel and that if you sell now, you may never be able to buy back in at this amazing price. Well, now you can buy about 65 shares for the price of 1 then. And with the demise of Worldcom, JDSU has even more of an uphill battle getting back to a positive cash flow.

Cutting Your Losses: Perhaps the most important lesson I've learned in this 2-year market downturn is the need to have a Stop-Loss strategy. The most difficult part of this is the notion that you don't lose your money until you sell. While this lie to yourself may be palpable for a 20 or 30% loss, maybe even a 50% loss, it's simply too much to bear when you're investment has lost 90% or more of it's value. So when do you Capitulate? I don't know what the answer is, but I think you're probably better off deciding this before you buy rather than when you're down 50% and not thinking rationally.

So before you buy, determine what failures would indicate that you were simply wrong:

Set a price as a Stop Loss point. (Warning! The next statement is so obvious that you may decide to P-Box me.) The biggest indicator of the value of a stock is the price. Sure you can analyze a stock all day, but if the price is going down there is probably a reason�and you may not know about that reason until it's too late. If you're convinced that the stock you're buying is worth $100, how low of a price would you be willing to go before you Cry Uncle? $50? $20? This price may be different for different people, but if you get to $20 and you don't have a strategy, then you might find yourself at $2.29 (the closing price of JDSU today) and still own a loser of a stock.

Lowering Estimates...Again! When a company lowers their earnings forecasts repeatedly, it's a good sign that they are uncertain about their future. AOL-Time Warner did this throughout 2001 and into 2002. The whole time, analysts were touting the stock and couldn't figure out why it kept going down in value.

The Sleep Metric: If you lose sleep over a stock, you probably need to adjust your position. This is your gut feeling. Trust it (unless it tells you to invest in a trans-oceanic fiber optic telecommunications company)!

So these are just a few of the lessons I've learned as a Fool. And I fully recognize that it may not do you a lot of good now that we have come down so far. However, I used this philosophy to sell out of several biotechnology stocks last month, and in doing so, I've preserved 30% of that capital. I just wish I'd done it a year ago.

Fool On,

Chris McAdams


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