The Hardest Part Of Investing & How To Do It Right

August 10, 2017

The Hardest Part Of Investing & How To Do It Right

  • Deciding when to sell a stock is the most difficult decision in investing. It’s much more difficult than deciding when to buy.
  • I’ll discuss 5 strategies that can go a long way toward helping you in making the difficult decision.

Introduction

The vast majority of the discussion around stocks is about what and when to buy. However, what’s even more important than buying is when to sell.

Knowing when to sell allows you to lock your gains in when you are right, limit your losses when you are wrong, and, most importantly, avoid selling for a small gain when the stock has the potential to double or more.

Financial markets constantly change. Interest rates change, a company can suddenly surprise with earnings, be it positively or negatively, a sector may enter into trouble due to too much competition, or a country can enter into a recession. On top of that, there are so many other things to account for that it would take writing a book to discuss all of the possible reasons to sell a stock. Nevertheless, in today’s article, I’ll summarize the best strategies for when to sell a stock and hopefully give you new tools to lower your investing risk and increase your rewards.

#1: Always Keep In Mind The Reason You Bought The Stock 

The easiest way to know when to sell a stock is by keeping in mind why you bought the stock in the first place and then comparing the developments in fundamentals to the changes in the stock price.

For example, let’s say you bought Berkshire Hathaway (NYSE: BRK.A, BRK.B) in 2010 because its price to book value was 1.35 and you considered it a safe investment as we all know that Buffett would immediately start buying back shares at a 1.2 price to book value. At that point, you said that no matter what, you would sell when the price to book value reached 1.5.


Figure 1: BRK’s price and price to book value. Source: Author’s data.

So BRK’s stock reached a price to book value of 1.5 in 2014. Thus, you would have sold only to buy back again in 2015 as the price to book value was again in your acceptable range. Toward the end of 2016, you would have sold again as the stock was again overvalued.

The easiest way to know when to sell is to compare how the fundamentals have changed in relation to the stock price. Various fundamental metrics can be used, from revenue growth, dividend yields, price earnings ratios, and others independent to the type of stock you are buying. Nevertheless, this is a selling strategy that imposes discipline and limits risks.

It’s easy for investors to get overexcited about a stock, not sell at the right moment, and lose all their gains and then some. A clear example of such a situation is GoPro (NASDAQ: GPRO) where the price to earnings ratio went to 166 in 2014 and those who didn’t sell have seen their holding lose 90% of its value.


Figure 2: GPRO’s stock price in the last few years. Source: Yahoo Finance.

Apart from fundamentals, there could be other reasons to sell a stock. For example, there are some catalysts that should positively influence a stock in the next few months, like the launch of a new product. If the product isn’t what you or the market expected, it’s ok to take a loss and sell because the circumstances have changed.

#2: Portfolio Rebalancing

If you own an all-weather portfolio, then the most important reason to sell or buy something is rebalancing. For example, the percentage of your portfolio exposure to gold assets jumps up because gold prices have increased. In such a case, it’s essential to lower your exposure to such assets in order to keep your portfolio risk weights balanced. And, given the volatility gold assets have, portfolio rebalancing is something you’d do often.


Figure 3: The Van Eck Gold Miners ETF (GDX). Source: Yahoo Finance.

Another reason to rebalance is because you have too much risk in one stock. If you usually hold 10 stocks in your portfolio and balance the risks, then each stock should have a weight between 5% and 15%. Now, let’s imagine you bought NetEase (NASDAQ: NTES) in 2009 when the price was $19.


Figure 4: NTES’s stock prices since 2009. Source: Yahoo Finance.

Fast forward a few years and NTES doesn’t make up 10% of your portfolio anymore, but 35% as NTES has increased 15 fold while the market increased three fold. Given the high proportion of risk in this one stock, it might be wise to trim the position since anything can happen, especially when such a large part of a portfolio is in one stock that has seen its price earnings ratio go from below 10 to above 20 in the last 5 years.

#3: There Is Something Better Out There

The first two strategies explained in this article are pretty straightforward, but the third strategy is already a bit more complicated.

Stock prices go up and down all the time and to be constantly trading around your portfolio just because this or that stock might look a bit better would mean high transaction costs would eat up all your returns.

However, I’ve found the best strategy related to this issue with the famous John Templeton. He would replace one holding in his portfolio only when another holding was 50% better than the first one.

For example, if there are two stocks where you think their true value is $100 while one is trading at $50 and the second at $40. By dividing the difference in price $10 with the price of the cheaper stock, we can see that the difference is just 25%. However, if the stock price of the second stock drops to $30, then the difference is $20 and it is now 66% cheaper than the first stock, thus it’s good to sell the more expensive stock and buy the cheaper one.


Figure 5: John Templeton’s rule for replacing a holding. Source: The Great Investors, Glenn Arnold.

A simple rule like Templeton’s trading rule helps keep a cool mind and the discipline necessary to be a successful investor.

#4: Using Stop Losses & Trailing Stop Losses

For an investor to use stop losses, it has to be an inherent part of their strategy because you sometimes lose with stop losses while sometimes you win. The benefits of using an automated trading order if a stock price drops below a certain target is that you avoid larger losses if the stock price drops even more and you eliminate the psychological difficulty of actually selling something when it’s falling.

On the negative side, the stock might be down temporarily, breaking your stop loss limit only to then surge again beyond your first entry point. In this case, all you record is a loss while your initial strategy was correct. For example, those who bought Apple (NASDAQ: AAPL) at $153 and set a stop loss at $150 a few weeks ago will have seen their shares sold at $150 while the stock quickly recovered and reached $156.


Figure 6: AAPL’s stock price in the last two weeks. Source: Yahoo Finance.

So use stop losses if they fit your strategy. However, an investor that should never use stop losses is a value investor because value investors usually buy more when a stock price drops if they follow the rules and only buy when there is a large margin of safety.

#5: Selling Because You Have Reached Your Goal

This is my favorite reason for selling and should be the happiest reason for when to part with stocks.

I certainly don’t want to be Buffett and die the richest person in the world. Or, as Steve Jobs would say: you don’t want to be the richest man in the cemetery. Nevertheless, I would love to achieve Buffett’s returns, but I would probably spend most of the gains as I have in the past.

For example, you and your spouse have a dream to take a year off to take a trip around the world and can finally afford to do it, there is an old car you always dreamed of buying and have the means to, you have the money to finally buy the house you always wanted or pay off all your debts. This may cost you a few millions in the long term, but somehow, I think that a few million more or less when you’re 85 will mean much less than enjoying life now, when we still have the strength and joie de vivre.

Conclusion

The five strategies above summarize what is best when it comes to selling stocks. I hope this article helps in making the toughest decision in investing, i.e. when to sell a stock.

Selling a stock might sometimes lead to lost future gains, but that is something we have to accept as normal. But sometimes you sell just in time before a crash. It all boils down to risk and reward.

In this market, the majority have forgotten what risk is and this will make the next crash very painful. Therefore, if you have enough money to live your dreams, you might want to really consider selling as you have much to lose and little to gain.