3 Questions to Ask Before Selling

Here's a mystery straight from the "odd things that investors do" vault: Why do investors continue to follow a stock's performance after having already sold it? If price gyrations in the stock have no impact on a portfolio, why bother?

Good question. In my case, I sometimes watch a stock much more closely after it has no part in my portfolio than when I actually owned it.

Why? Because I want to feel good about my sell decision. I want to know that I made the right choice. A stock that tanks after I sell crowns me as a market seer, and one that shoots higher goes in the "just kick me" file.

Aside from my own delusions, though, I've learned that my post-sale paranoia is evidence that I sold a stock with more emotion than reason. If I were selling for the right reasons, I'd show much more confidence in the decision and have little need to validate the choice.

Don't look back
There are cases, however, when I've sold a stock and just moved on. For instance, I had no such problem when I sold the vast majority of my Lucent Technologies holdings -- I've never looked back on that one. But Lucent, which was recently merged with a French rival to become Alcatel-Lucent, had some very obvious fundamental problems that made that decision pretty easy. Most other sell decisions are not as clear-cut.

So what are the "right reasons" to sell, then -- the ones that investors can employ with confidence? Unfortunately, no script for sell rules exists. Each situation has to be evaluated in its own light. But to deal with those agonizing decisions, I jotted down three quick questions to help make the determination. Surprisingly, simply answering these questions has saved me from making several bad choices with investments.

Question No. 1: Am I thinking about selling this stock based on thoughtful analysis of the business, or just general market panic?
Consider the market gyrations over the past year. Investor confidence has been shaken in a number of areas: housing bubble fears, the uncertainty of regional conflicts, and options accounting investigations. Looks like a surefire recipe to sell stocks and run for safer investing grounds, eh?

Judging by where some of these popular stocks are trading today, many investors have bought into the pessimism:

But bad moods, unfounded fears, and "general market sentiment" shouldn't shake you loose from a company that is still fundamentally the same as when the market's mood was peachier. Granted, some of the declines can be explained fundamentally, such as Sprint Nextel's disappointing customer retention metrics as the company struggles to integrate two huge wireless carriers. But not even some strong financial metrics from AMD and its acquisition of ATI were enough to excite the bulls this past year.

Question No. 2: Do I have a plan for where the proceeds of the sale will go next?
I've found that almost every time I have no plan to put freed-up cash to work, I'm making an imprudent choice to sell. It makes sense that you should sell only when you've concluded that there's somewhere else your money would be better invested, or spent. For instance, I've known some people who have sold very successful investments in Qualcomm to purchase other stocks that are younger and show similar promise. It wasn't that Qualcomm was a bad place to keep money invested; there were simply better opportunities elsewhere.

Selling one stock might not be done necessarily to put funds into another stock, though. It could be done to add money to a quality fund or other investment to diversify a portfolio. It could even be liquidated to pay off high-interest debt that you've recently accumulated. Either way, the money should move to something better, not just an idle account that earns little interest.

Question No. 3: Have the original reasons or assumptions I made about the stock when I bought it changed significantly?
This entails asking hard questions about the business fundamentals and the market or markets a company is pursuing. Investors should regularly check the fundamental drivers for a company's growth and look for warning signs that point to potential trouble.

There may have been changes in management or a buyout of the company altogether. Perhaps the company has shown lackluster operational performance, regardless of the potential often cited in press releases. It's also possible that the company, analysts, or even you overestimated the size of the potential market. Any of these or other changes could tip the risk-vs.-reward ratio of a stock out of your favor and provide a solid basis for parting with shares.

Expect imperfection
Realistically, investors should expect to be imperfect at selling investments. Even the best investors lament at least a few huge opportunities cut short by an ill-timed sell. In the end, though, the goal should be to ensure solid reasons to cash out of a stock, not just anxiety or emotion.

Fool co-founders Tom and David Gardner ask the hard questions when selecting two promising stocks each month for their Motley Fool Stock Advisor service -- and they ask even harder questions when they recommend selling. Their average performance of 68% vs. the S&P average of 29% confirms that they're not easily parted with some of the market's best opportunities today. A free 30-day trial gives you one-click access to detailed write-ups on all of their buys and sells, with the reasoning behind them.

This article was originally published on Aug. 11, 2006. It has been updated.

Fool contributor Dave Mock counts selling his old car as a good decision, but not for the buyer. He owns shares of Alcatel-Lucent and Qualcomm. A longtime Fool, he is also the author of The Qualcomm Equation. That's how the Fool's disclosure policy rolls.