Buying and selling shares is simple to do but understanding when to do so is much more complicated. Imagine a stock you own is falling in value and the investors keep selling off – the stock is down 20%, should you sell it? As an investor, it is important to have a distinct rationale behind your decisions to buy and sell shares, this article will highlight some key tips for you to consider when making your investment decisions.
Tips for when to buy shares
Invest in what you understand
The first step to deciding when to buy shares is to understand what companies you are interested in and operationally understand. This is one of Warren Buffett’s central investment philosophies – to “Never invest in a business you cannot understand.” and in 2021 that hasn’t changed. Whilst many successful investors don’t follow this idea completely, the premise is highly important. If you don’t understand the sector the company operates in nor its business model, then you are going to be unable to forecast its future success. Make sure that even when you see a stock following a strong price trend, that you consider this, if you don’t, you may have just bought the stock at its peak.
Understand the Investment Environment
Before looking at individual companies, you should take a step back and look at the market from a macro perspective and observe what the current trends are. Regardless of what shares you invest in; these overarching factors will play a large role in their success. Thus, it is important to understand the current economic movements and recent news. For some industries, certain factors play a much larger role – for example, the Australian Mining industry’s performance is strongly tied to the performance of the commodities they are mining as well as long-term client relationships. With political strains with China in recent times, trade restrictions have a tangible impact on many mining stocks. Once you have developed a macro perspective, you can utilise these insights in evaluating which sectors you are interested in investing in, which can simplify your decision-making by focusing on fewer industries and understanding the broader risks.
(Almost) Always be invested
Time in the market vs Timing the market, realistically timing the market is extremely difficult to do and tends to be more based on speculation rather than grounded long-term investment theses. Whilst you should consider the impact of market cycles on your investments, you are more likely to succeed if you keep your capital invested for a longer period of time instead.
Assess the company’s financial position
Instead of considering when to buy stocks, your focus should be more weighted towards which stocks to buy. An effective way to do this is by looking at their financial results and ratios. These include Price to Earnings which reflects the earnings potential of the business from the market’s perspective and the Return on Equity ratio which measures the company’s profitability. These ratios can assist you in comparing the target company to similar ones and the industry. Prior to the release of financial results – which companies schedule to be announced on certain dates, if you are bullish on the company’s financial performance relative to market expectations, then you should consider buying the share as an earning season approaches – as if you are correct, the price of the stock will likely jump up to adjust for said performance.
Tips for when to sell shares
Your investment thesis has changed
When deciding to sell shares, take some time to think it through relative to your original investment thesis and ensure that it isn’t a compulsive decision. Selling shares can be an emotional task associated with risk and damage control just like buying shares can be driven by a fear of missing out on the next huge growth stock. When investors buy into a company, they do so with the belief that the company will perform well, and yield returns for them. This comes down to their faith in the company’s growth initiatives, stability, and strong management team. If the benefits of these growth initiatives are not being realised or there is a reshuffle of the management team, investors may reconsider their investment as it no longer matches their initial purchasing rationale. Furthermore, you should consider whether the industry trends are in alignment with what you expected and whether they are having a material impact on your company’s performance. If they are, investors may begin to look to exit their position.
The intrinsic value relative to the market price
Besides speculation and market imperfections, a company’s share price ultimately approaches its intrinsic value, which is a calculation of how much the asset is actually worth. If the intrinsic value of a business is falling, compounded with other factors such as tapering growth potential or overleveraging for inorganic growth, then these may be strong signs that the price is going to fall. Similarly, if the market price significantly exceeds the company’s intrinsic value, then it may be a good time to sell the stock for a profit since the price is inflated relative to its performance.
Adjusting your portfolio
To maintain diversification and control risk exposure, investors will sell stocks to rebalance their positions. For example, if an investor just purchased a large number of shares in a mining company, they may want to sell other shares they have in mining to control their exposure to the industry’s risk. This also applies vice versa however, where an investor may sell stocks, they own in one sector to finance their bullish view of another one. It is always important to keep in mind these factors when investing, whilst all your stocks may be performing well if they are all within the same industry or ancillary ones, then your investments are much more exposed to one industry-related event than another investor who has shares in companies from a variety of industries.
If the company is being acquired
When a company is acquired by another company, the acquirer will offer the target company’s shareholders a premium on its existing stock price in the form of either cash or the acquiring company’s stock. If you have high conviction in the success of the acquirer and the offer is purely in stock you should not sell. However, if it is a mix of pure cash you should consider selling it as the market tends to adjust towards the acquisition price. Sometimes, these deals fall through at the end, which results in the stock losing its premium market valuation. Given the low success rate of acquisitions being value-generating, overall, it is generally better to sell the stock and reap the profit.
If you need the money
Whilst you generally shouldn’t invest in shares when you know you will need the money in the near future, selling due to financial needs is still completely valid. However, you should still avoid this practice as it could force you to sell in poor market conditions leading to dampened returns or even a loss. However, you may also require the money to invest in another stock you believe is going to perform well. In this scenario, you may want to consider whether the opportunity cost of selling at a suboptimal price is worthwhile to position yourself in your new investment target.
Buying and selling shares for the correct reason can be hard, and timing when to do so is not an easy feat. Ultimately, it comes down to you knowing your investments, their respective industry landscapes, and remaining consistent with your investment philosophies unless you have a distinct rationale as to why it has changed.