We have heard many investors lament how difficult it is to know when to sell a stock. There are numerous guidelines that can be used to decide when to sell a stock.
Try to Sell At or Near the Top. This is an ideal solution, and one that everyone has tried to attain at one time or another during their investment experience. Unfortunately, it can't be done on a consistent basis. Yes, the element of luck can help you achieve this once in a while, but not with any predictable or consistent success. You'll need to adjust your expectations about the feasibility of this solution, or you'll be constantly frustrated. Even legendary investors Sir John Templeton and Warren Buffett readily accept the fact that selling near or at the top consistently is an unrealistic and unattainable goal, and you should too.
Sell After a Predetermined Amount of Appreciation. Some people like to sell if and when the stock appreciates by a predetermined percentage. Investors who use this sale method are usually heavily influenced by the Wall Street adage, “Nobody ever went broke taking profits.” In our view, such mechanical formulas are not particularly helpful. A stock does not know how much paper profit you've made. If a stock was previously highly undervalued and/or the intrinsic value of the underlying business is growing over time, there is no reason why a stock enjoying great appreciation cannot continue to increase over time.
Sell After a Predetermined Amount of Depreciation. Investors employing this approach sell any loser once it drops below a certain price. This approach has at least one salutary aspect. Any successful investment strategy ought to be designed to limit the damage inflicted by some inevitable losers in the portfolio. A good defense is perhaps more important than a sound offense. A sale discipline intended to cut losses early certainly advances this goal. One weakness of this approach, however, greatly limits its benefits. Since short-term movements in stock prices can be quite random, and are more affected by mass psychology and emotions than fundamentals, you could likely end up selling a stock that has dropped in price due to temporary and perhaps non-fundamental factors. By the time you realize this and try to buy back in, the price may have already increased beyond your reach.
Wait to Sell a Loser Only After It Breaks Even. This type of thinking is prevalent and unsurprising. Psychological studies have shown that for most people, the pain associated with losing money is greater than the joy they experience from making money. Emotionally, investors find it very difficult to lock in losses. The decision whether to keep holding is made more difficult by the fact that the turnaround for some losers is well worth waiting for while others may never materialize. Losers all look the same while they are down. You need both knowledge and expertise to distinguish between losers whose lower prices are justified by the likely diminished long-term business prospects, from those with genuine turnaround potential. Stubbornly waiting for a turnaround that is unlikely to materialize would tie up capital which can be better utilized for other investments.
PDV's Sale Guidelines. Here at PDV, we generally sell under one of four circumstances: a) the stock has become grossly overvalued, b) after taking tax and transaction cost considerations into account, a much more compelling investment comes along, c) subsequent events following our stock purchase have demonstrated an unexpected and likely permanent deterioration in business value that does not appear to be adequately discounted by the current stock price, or d) the stock has become too large a position (generally defined as over 10% of the total assets under management).
"Grossly overvalued" means that the stock price has exceeded the top end of a range of reasonable business values for the underlying company and incorporates some unrealistic assumptions about its profitability, growth rates and other financial and operating factors that appear very difficult to achieve.
Most of our sales are of grossly overvalued securities that have appreciated. These stocks are almost always experiencing positive price momentum at the time of our sale, as the formerly out-of-favor stocks are being once again embraced by the investment masses. Short of luck helping us catch the top, these stocks will probably continue to climb after we sell because of the positive sentiment surrounding them. Therefore, there's almost always a short-term opportunity cost to selling because our clients would probably continue to benefit from a rising price had we not sold (at least for awhile).
We counsel clients not to get frustrated if a stock continues to go up in value after we sell, which will happen frequently. As the price of a stock increases in relation to its business value, the future appreciation potential is becoming more and more limited; it is preferable to sell and reinvest the proceeds into some investment that may not have the same momentum right now, but which offers greater appreciation potential down the road. It is a case of foregoing immediate gratification to achieve greater future delayed gratification. If we were to wait for the existing investment to lose momentum before switching, the more undervalued opportunity may no longer be available at such an attractive price at that time.
We are willing to incur this short-term opportunity cost because doing so actually yields greater benefits for our clients over the long term. We would not sell any stock unless it was grossly overvalued. By definition, an overvalued stock has limited long-term appreciation potential (since value and price converge over time), even if investor herd mentality might continue to push the stock price up in the short run. On the other hand, any sale proceeds will be redeployed into undervalued securities (which by definition offer greater long-term appreciation potential.)
Our sale discipline, therefore, can make us look bad in the short run, because we are exchanging stocks with positive price momentum with those usually experiencing negative price momentum (that's why we can buy those cheaply, because they are out-of-favor and undervalued.) But in reality, we are rebuilding the foundation that will likely sustain better long-term returns for our clients than if we had stayed with the overvalued stocks, because we've increased the long-term appreciation potential embedded in client portfolios. We are willing to look foolish in the short run if we are in fact doing something intelligent in the long run to benefit our clients and their portfolios.