It’s a safe bet many of us are pondering whether to sell some stocks in our portfolios these days.
Knowing when to sell a stock is as important as knowing when to buy one. We don’t want to sell winners early, but we also don’t want to hang on to losers long.
But how do you know when it’s appropriate to sell?
Let’s explore this question today.
Be a quitter: don’t be afraid of selling
Investing is hard.
Having a success rate of 100% is not feasible. So getting it wrong is part of the game.
But promptly realising one’s mistakes, rectifying them, and accepting them is a psychological challenge.
Strangely, the solution is often to become good at quitting.
Scott Fearon, a respected fund manager, wrote about the virtue of quitting in his book I highly recommend called Dead Companies Walking.
As Fearon wrote:
‘I’m not perfect at what I do, by any stretch, but I am a very good quitter. I’d say I’m one of the better quitters I know. And that skill has helped me a lot over the years.
‘Like I’ve said, the best money managers are also the best quitters. They quit early and they quit often. As soon as they see things turning for the worse, they don’t wait around, they bail. This same quality is just as important in business. That’s not to say that tenaciousness isn’t important or that faith in your abilities and your ideas is a bad thing somehow. But you have to separate faith from blind faith.’
Why is being a good quitter important?
It lessens the chance of you riding a losing stock all the way down.
As I’ve said, investing is hard — made harder by the fact that the stock market contains more businesses that fail than succeed.
The Reserve Bank of Australia estimates between 15,000 and 20,000 firms fail each year.
Mistakes, misjudgements, and just sheer bad luck are inescapable. But if you can handle that better than others, you’re already a step ahead.
It’s OK to be wrong, not to stay wrong.
I’ll leave another excerpt from Fearon here:
‘If you want to be a good investor, learn to be a good quitter. Quit early and quit often.
‘And you might as well make friends with the feeling of disappointment, because it’s certainly going to make friends with you. No matter how smart or savvy you are, if you play the markets, you’re going to spend some up-close-and-personal time with your own fallibility, because failure in the stock market happens all the time — even to the most accomplished professional money managers in the financial industry.
‘And yet, just like in the corporate world, most investors refuse to acknowledge this inescapable reality. That denial leads to some all-too-common mistakes.’
By the way, on the topic of quitting more often, I recommend listening to this early podcast from the Freakonomics duo Steve Levitt and Stephen Dubner.
So with that disquisition on quitting out of the way, when should you sell a stock?
Knowing when to sell: questions and checklists
It’s important not to base your selling decisions on emotion.
Often, when a stock is down 20%, 30%, or 50%, it’s hard to keep emotions in check.
But keeping emotions in check you must.
Panic, fear, or FOMO are not sources of sound decisions.
The trick is to sequester your emotions and assess a situation in as objective a way as possible.
Respected investment strategist Michael Mauboussin made a case for checklists in a research piece for Credit Suisse (emphasis added):
‘The use of a checklist is one approach to making good decisions under pressure. In his superb book, The Checklist Manifesto, Dr. Atul Gawande describes two types of checklists. The first is called DO-CONFIRM. Here you do your job from memory but pause periodically to make sure that you have done everything you’re supposed to do. The second is called READ-DO. Here, you simply read the checklist and do what it says.
‘READ-DO checklists are particularly helpful in stressful situations because they prevent you from being overcome by emotion as you decide how to act. You can think of your emotional state and the ability to make good decisions as sitting on opposite sides of a seesaw. If your state of emotional arousal is high, your capacity to decide well is low. A checklist helps take out the emotion and moves you toward a proper choice. It also keeps you from succumbing to decision paralysis. A psychologist studying emergency checklists in aviation said the goal is to “minimize the need for a lot of effortful analysis when time may be limited and workload is high.”’
So what kind of READ-DO checklist would help make a rational decision when you ponder selling a stock?
At its core, a sell decision occurs for three potential reasons:
- Stock has reached or surpassed its intrinsic value
- Better opportunities exist (rising opportunity cost)
- Stock’s intrinsic value and fundamentals have deteriorated
Stock has reached or surpassed its intrinsic value
This is tricky.
Selling a stock because you think it’s reached its intrinsic value makes the most sense only if you think the stock has no further upside.
If you think a stock has little further upside, then holding the stock makes little sense as you can earn better returns elsewhere.
Not to mention that if others start sharing your view that the stock has little remaining upside, it may trigger a sell-off.
But keep in mind that investors often sell winners too early while holding on to losses too long.
Better opportunities exist (rising opportunity cost)
Are there any laggards in your portfolio? Have you spotted a better opportunity with the potential of higher returns than a stock you currently own?
An opportunity cost is the value of your best alternative, the road not taken, the stock not bought.
For instance, the opportunity cost of watching a whole season of Stranger Things in one night is what you give up doing that — finishing Infinite Jest, or cleaning the house, or starting a coding course.
What are the opportunity costs of your portfolio?
If a stock’s returns and prospects are lower than the stock’s best alternative, the opportunity cost is too high and better opportunities exist.
Stock’s intrinsic value and fundamentals have deteriorated
Have you reassessed the outlook of the stock to the downside?
Have the fundamentals of the stock changed in a negative way, such that the intrinsic value is now lower than the prevailing market price?
Has the fundamental picture changed?
Here it can help to hear Morningstar’s Pat Dorsey, who advised:
‘The key is to constantly monitor the companies you own, rather than the stocks you own. It’s far better to spend some time keeping up on the news surrounding your companies and the industries in which they function than it is to look at the stock price times a day.’
So in the spirit of a checklist, here are some questions you can ask yourself when pondering whether or not to sell a stock:
- Have you made a mistake? Did you miss something? Was your initial analysis to buy the stock flawed?
- Have the stock’s fundamentals changed?
- Has the stock’s price risen too far above your estimate of intrinsic value?
- Are better opportunities out there? Can my money be put to better use elsewhere?
- Are you invested too much in one stock? Do you need to rebalance your portfolio to mitigate risk?
For Money Morning