The 3 Good Reasons to Sell a Stock, No. 2: Portfolio Management

In this episode of Motley Fool Answers, hosts Robert Brokamp and Alison Southwick want to focus on one question -- but it's a big one, especially for long-term investors: When should you sell a stock? To provide the answer, they've tapped Motley Fool Chief Investment Officer Andy Cross and Ron Gross, the advisor for Motley Fool Total Income.

In this segment, they talk about the second of three good categories of reasons: The need to keep your portfolio aligned with your financial plan. The Fools discuss why you don't want too much of the money you know you'll need to spend soon to be held in stocks, the ins and outs of rebalancing vs. letting your winners run, harvesting tax losses, and more.

A full transcript follows the video.

This video was recorded on Aug. 14, 2018.

Ron Gross: The next bucket we came up with is portfolio management reasons to sell. This is near and dear to my heart as a former portfolio manager, but a lot of these are actually Foolish principles and not typical mutual fund or hedge fund principles. Certainly the first one is.

If you need your money in the next three years, your portfolio should not be fully invested, as in my example where I have a couple of years of college on the horizon. It's inappropriate, in our opinion, to have that money in the market because you will not have the time to weather a severe correction, which inevitably will come. That's our best advice for that.

A position becomes too large. We heard someone earlier say that would be a reason to sell. Now, the words "too large" is in the eye of the beholder. What is too large? For me, too large is 5-7%...

Andy Cross: Really?

Gross: Yes, that's my conservative nature. But for some, 25% would be fine if one stock was a quarter of your portfolio and you could sleep at night.

Cross: And from the perspective of letting your winners run, hopefully those stocks naturally gravitate and make up more and more of your portfolio, and the losers make up less and less. That's what you want to see. Warren Buffett has talked about this, too. Those big stocks make up a larger and larger percentage of your portfolio, but it really is down to each individual investor and what you feel comfortable with.

Especially if they may be a little bit higher beta or higher growth stocks, or the valuations might start looking a little bit on the higher side, understanding those stocks could very quickly be cut 20-30% and how that would make you feel with your portfolio [is important]. The last thing you want to do is act irresponsibly if that happens. That's where you want to be very comfortable with that weighting level.

Gross: You found a better opportunity is an interesting one because it applies more to those folks that are managing a fixed portfolio; one that they're not adding too consistently. If you are managing a fixed portfolio, you ideally want that portfolio to be represented by your best ideas at all times. And if you're fortunate to uncover a great idea, you may have to make a tough decision to sell your worst idea, even though you may like it, to free up capital for the new opportunity.

We don't like to do that. It's hard to sell a stock that you've lived with for a long time, especially if you are a long-term investor; but if you want to maximize your returns and optimize your portfolio; again, I think sometimes it's necessary. If you're able to add money then it doesn't become as necessary, because you can just buy that new stock and always be happy with the next new one.

You need to rebalance. This largely is based on your life experience where, let's say, as you're getting older you don't want as much exposure to stocks. Bonds may be appropriate. Cash may be appropriate. Alternative vehicles other than stocks may make sense to you. In those circumstances, rebalancing [reducing your position in stocks and increasing your position in other types of investments] may be necessary. It may help you sleep at night. It may optimize your returns better for your stage of life.

Cross: Financial advisors love this [no offense to financial advisors out there or [those who] work at The Motley Fool], but they talk about rebalancing monthly. Quarterly. ETFs do it all the time. Because we trade so infrequently, and we sell so infrequently, our portfolios tend to be very tax efficient and we don't have a lot of churn. That means that our portfolios would look out of balance relative to what a financial advisor may recommend based on some efficient market theory.

But it does happen, and if you do have money with a financial planner, you will be asked about rebalancing your portfolio. A lot of this gets to comfort level, but you hear that from financial advisors all the time. "Oh, we've got to rebalance your portfolio. Get you more international exposure and sell some of your Netflix when it's at $26."

Gross: Harvest tax loss is another one that financial planners like. There are times where taking a loss to offset a gain will make sense. Most of us probably don't focus on that too much, but it can be financially beneficial. We're all fortunate that long-term capital gains rates are relatively reasonable at about 15%, but there are certain times where you can offset a big gain by taking a loss on a company that perhaps you're not too fond of and being able to keep more of that gain that you generated in a particular year.

Cross: When to Sell: Psychology and Life Choices. I mentioned a little bit about behavioral finance and how we interact with our investments and how we treat our investments. A big one, here, is you're losing sleep over the investment. I mentioned that earlier. Again, if it causes stress and meditation is not helping with that stress... [or exercise, eating lots of chocolate, or whatever you choose to do], if you're losing sleep, it's not worth it. I have been in that situation where I've had stocks that would qualify probably for some of the earlier ones from a valuation perspective that I didn't sell. It actually ended up hurting our returns because the stock had underperformed. I didn't feel comfortable with it, so I should have parted ways with that. I literally was losing sleep over it, which is not good...

Gross: It's not good.

Cross: ... because there is an investment for you.

Gross: Your ethics. At The Motley Fool, we try not to put our ethics on to you through our recommendations, because everyone is obviously different, but I do encourage you to take your ethics and morality into account when building your portfolio.

And whether it's not being comfortable because you think Facebook may not be what you thought it was, or it's a tobacco stock, or it's a company involved in genetic engineering; whatever it is, I think it's perfectly reasonable to have your portfolio reflect your values. David Gardner often says the best world that you can envision is what your portfolio should reflect. I don't say it as eloquently as he does, but that's the gist. I think it's perfectly acceptable to take your own ethics into account. And if something at a company changes, it may be time to say goodbye.

Cross: We invest to make money for ourselves -- for our future, our families -- and to put it to use. So if you need that money to be put to use for some reason [family income situation has changed or you want to buy a home] you're going to have to sell some stocks. Even David Gardner did a few years ago and wrote a note to Stock Advisor members on why he was parting with some of his investments. He was switching homes. So, if you need to use the money, most likely you'll have to sell that stock.

Gross: The same goes for being charitable, whether it's giving money to family members or to a charity and taking advantage of the $15,000 gift tax exclusion on an annual basis. Sometimes it either becomes necessary, or you desire to free up cash for charitable reasons, or to pass it on to the next generation. That's a great reason to sell, as well.