Knowing what and when to buy are typically the questions that investors focus on. But knowing when to sell is just as important. In the absence of a clearly defined exit strategy determining when to sell a stock can become a daunting decision. But there are several methods that can make the decision-making process more straightforward.
Reasons you should sell a stock:
Your investment thesis no longer holds
It is often the case that when deciding whether sell a stock, returning to the reason you initially bought it, can provide clarity.
When you buy a stock based on its fundamentals, the decision to sell should also be based on its fundamentals, as opposed to short-term price movements. In the event of adverse price movements, you should reevaluate your investment thesis and make the decision accordingly.
By analysing the company reporting, you can monitor if the reasoning behind your investment is still valid. For example, if you are looking to invest in a stock for income, you should also decide when to sell it. These reasons may be because of a:
- Dividend cut: Companies can sometimes cut dividends and this may signal a worsening financial condition, however it may also imply cash being reinvested into the business. Hence, an accurate assessment should be made before you choose to sell.
- Rising debt levels: Debt is the strongest form of liability a company has to pay. Note that most that companies that go bankrupt signal that they are unable to pay high levels of debt.
- Material risk to their earnings outlook: A company’s ability to provide shareholder returns reduces drastically if its operations and fundamental strength reduce. In effect, shareholder returns would be dismal if the company itself is struggling to grow. Be observant of management’s commentary in annual reports and take particular note of the tonality of the language they use.
If the reason you bought the stock is no longer true it provides a clear signal that you should sell. As Warren Buffett says:
“if you find you’re in a bad investment, stop throwing money at it. Though it’s painful to pull out, in the end it is far more profitable.”
The share price is fully valued
As your investment thesis plays out and the share price increases eventually your target price will be reached. Your target price should be driven by fundamentals and some techniques to do these include valuation multiples and DCF modelling. It is best to distance your emotions as much as possible through a disciplined approach.
It’s nearly impossible to pick the top and if your target price has been reached and the company valuation is starting to appear stretched, it is likely a good time to sell down the position either partially or in its entirety to crystalise your profits.
While investment decisions should not be driven by tax, investors often avoid selling shares due to their aversion to paying capital gains tax. If possible, you should take advantage of the capital gains tax discounts received from holding a position for more than 12 months. However, it is also important to notice that with a stock that has seen a significant price appreciation for a prolonged period, the risk of retracement increases, and the magnitude of the retracement could exceed the taxes you would have paid had you sold.
At the crux of it all, it really boils down to opportunity costs and ‘cost-vs-benefit’ decisions.
If the company is subject to a takeover
When a company is subject to a takeover there is often uncertainty as to what you should do. Do you wait for the deal to close, wait for another offer to come, or sell your position?
After a takeover bid is announced, the share price of the company being acquired typically sees a sharp price increase and will trade close to the proposed deal price. Unless there is a subsequent bid or an increase in the offer price there is usually limited upside remaining and as such in the absence of another likely acquirer it is often the best course of action to sell rather than waiting for the deal to close. This also minimizes the risk of the deal falling through which typically results in a sharp share price decline.
Your portfolio becomes imbalanced
Your portfolio can become imbalanced for a number of reasons. The most common being that a single stock or sector has outperformed leaving the portfolio overweighted to that company or sector. While you may be hesitant to sell your best-performing position, you should remember that selling doesn’t have to be an all-or-nothing approach.
It’s often impossible to pick the top and if the company is beginning to trade on a more stretched valuation, it is logical to trim the position. Position trimming comes with its own perks and allows you to:
- Reduce your exposure to any single company or sector
- Maintain your cash allocation and free up capital for other investment opportunities
It also may be the case that your changing investment goals create a reason to sell stocks, a change in your risk appetite for example would involve selling growth companies in favour of fixed income securities or blue-chip companies. In this instance, there may be nothing wrong with the existing positions but adjusting your portfolio weighting can provide another sensible reason to sell.
Other investment opportunities and personal expenses
As mentioned above, maintaining a cash allocation can allow you to take advantage of any investment opportunities or cover unexpected personal expenses that may arise. This is achieved by trimming positions to maintain a certain percentage of the portfolio in cash.
In a perfect world, you would have enough capital to take advantage of new investment opportunities as they present themselves. However this is not always the case, and it is likely that you may not have enough to acquire your desired position size.
In this instance selling an existing position and reinvesting becomes a logical decision. Again, there may be nothing wrong with the existing position but identifying a more attractive opportunity with greater upside provides a compelling reason to sell.
You hit a stop-loss
A stop-loss can provide you with a good risk management tool that filters out the emotional and temperamental attachment most investors have in their decision-making process. They allow you to limit potential losses by selling a stock if it reaches a certain level below your initial purchase price.
Determining where you set a stop-loss can be dependant on a number of factors including your risk tolerance and the share price volatility. By setting a pre-determined stop-loss you can implement a much more clinical risk management process, and is a service offered by Maqro.
When you shouldn’t sell a stock?
Short-term price share movement
Short-term share price movements alone should not be the sole factor to determine if you should sell a position as these are often unrelated to the underlying business. Share price action on its own both up and down can create a lot of noise but providing your investment thesis still holds it should not dictate your decisions.
As the share price of your position moves up crystalising a profit can become more tempting however, this also limits the potential upside of the trade. Depending on your initial analysis and the fair value you determined it may still be materially undervalued. In this situation, the best decision typically is to continue holding the position until it hits your target price range to maximize the potential upside and take advantage of its price momentum.
Just because the share price has moved against you doesn’t mean you should immediately panic-sell the position. Firstly it is important to develop context. Some questions you can ask yourself are:
- Have there been any price sensitive announcements?
- Is the wider market experiencing a dip?
- Have the companies’ competitors seen a similar dip?
By doing this you can avoid selling at a loss only to see the stock recover soon thereafter. Stocks often recover from short-term volatility so even if there are dips it is often in your best interest to hold the position providing your investment thesis still holds and you have a stop-loss in place.
Tax-loss selling is a strategy that involves selling investments that have incurred a capital loss in order to reduce your net capital gains for the financial year. While there are advantages to tax-loss selling, it shouldn’t be applied indiscriminately to your portfolio.
Rather, you should use tax-loss selling in conjunction with the previously listed reasons by identifying and selling underperforming non-viable positions while retaining those that still has substantial upside potential.
- The importance of your investment thesis and target price in determining if a stock should be sold and at what price profits should be taken
- The role selling plays in risk management by maintaining target portfolio weightings and through the introduction of stop-loss orders
- Short-term price movements shouldn’t be the sole reason you sell a stock
This should provide a snapshot of the factors you should consider in order to make the most informed decision when it comes to selling a stock. It is in no way a definitive guide but should serve as a stepping stone towards developing a process that works for you and your investment strategy.