The fact remains that no matter how much money you make in a stock, you haven't made anything until you sell. Unrealized profits do not lift your bank account, realized gains, however, do. Why then is it impossible to find any decent advice about when (and how) to sell a stock? You certainly won't hear it in CEO interviews as those guys wouldn't be caught dead saying a negative thing about their stocks. Mutual funds follow suit as their businesses revolve around assets under management. They have to be permanently bullish about stocks regardless of the financial picture. Most pundits still subscribe to the philosophy of buy and hold which after ten years of stagnant growth seems to be outdated.
Granted, the stock market has never lost money over any twenty year period when you include reinvesting your dividends, nevertheless, there are undoubtedly times when the sell call needs to be made.
There are myriad reasons investors sell a stock but only two are completely viable:
- The stock has made you money
- The stock has or is going to lose you money
For many people buying a stock is easy but selling can be excruciatingly hard. Why? Well for one maybe the stock has made you a lot of money so it's hard to part with it even though you rightfully know it can't go up forever. Or two, the stock has went down and the actual action of selling cements the fact that you were both wrong and you won't be getting your money back on that particular investment idea.
Nevertheless, as investors we must realize that the stock market is an ultra-dynamic place that is constantly changing. An idea that worked 1 year or even 1 month ago may not work today. That is why flexibility is key. You must understand that when an investment goes against you, to hit sell before it gets too ugly. Also, don't become too attached to an individual stock. Remember, ultimately it's a piece of paper that is connected to a company. If you are emotionally attached, you will hold on to the stock for too long when you should have sold. Now, let's look more deeply into the above notion of selling a stock that has made you money.
Taking Profits in Your Winners
When a stock you own has run up 20% or more in value you should probably consider taking a little bit off the table. This means to sell some but not all of what you own. As a stock goes up in price it gets inherently more risky. No matter how much you may like Starbucks (SBUX), for instance, the stock is riskier at $80 then it is at $50. If you bought the stock at $40 and it is now at $80, you've made a solid double and should sell some of the stock. If you don't, you're being greedy. It's as simple as that. As I mentioned in a previous article titled, "How to Buy Stocks Like the Pros" incremental buying and selling is the way to go. Never sell (or buy for that matter) all your stock at once.
So going back to the Starbucks example, when I have a stock that has doubled I like to sell off my original investment (which is now half since it doubled) and leave the rest on the table, considering I still believe in the stock. In essence, you are playing with the houses money. If the stock then pulls back a little bit from there and possibly some negative news has come out about the stock you can sell the rest, locking in a nice profit. On the other hand, maybe the stock continues to soar and you'll make even more money. Would you have made more by leaving it all in? Of course you would have. However, the market is about risk versus reward. Too many people have gotten a double in a stock, but then out of greed they didn't sell only to see the stock plummet back down to its original value. This makes my stomach seize up even writing those words because it has happened to me and probably to anyone who has been in the game for a while. The moral of the story: don't be greedy with your winners. No stock has ever gone to infinity. Eventually, it will come down.
Cutting Losses in Your Losers
Picking winning stocks is a time-sensitive and sometimes capricious endeavor. Although it can feel like luck or gambling to some, I truly believe that with research and hard work it is certainly attainable for anybody to make money in the market. Nevertheless, nobody will be right 100% of the time. That means we need to know what to do with our losing stocks. In layman's terms: how do we sell a stock before it blows up in our face and ruins our entire portfolio?
The answer to the above question of when to sell is when the story, or reason you bought the stock, changes. Let's revisit Starbucks... Imagine that you bought the stock for the following reasons:
- Exciting new acquisitions such as Teavana
- Lower commodity (coffee) prices
- Superb management led by CEO Howard Schultz
- The new Verismo product
Now, these are all excellent reasons to buy and when you add them all up you may have a winner. But, even with all of the excitement and positive things going on around the stock, things change. Remember how I mentioned above that the market is dynamic? It's possible that at any time Howard Schultz could step down as CEO and anytime the CEO leaves it is a true red flag. Furthermore, Starbucks could report in their quarterly earnings that the Teavana acquisition is not doing as well as expected or that coffee prices are set to rise which in turn would lower their margins. There are innumerable things that happen after you buy a company. Once you purchase the stock follow it and constantly do homework. Don't let your guard down and when the story ultimately changes and the reason you bought it no longer exists, then it's time to sell.
One Last Caveat
Many new or amateur investors will hold onto a stock that is down just waiting for it to get back to even so they can sell. Listen up. Some stocks never get back to even. This is a sucker's game that is only played by the truly naive and inexperienced investor. There are plenty of opportunities to make money in the market at any given time. As I mentioned in the previous paragraph, if the story changes please sell. If not, you'll be holding damaged goods when you could have invested in something that will lift your portfolio too new heights not anchor it down at frustrating lows.