24 October 2016 12:00 am Views - 1845
When investing in the stock market we focus a great deal on purchasing stocks. We refer research reports and consider experts’ views prior to making a decision. Unfortunately, such diligence is not observed when selling stocks. However, if we are to maximize returns in the market, we should extensively focus on both, purchases and sales.
Selling stocks is hard for numerous reasons. We are almost always forced to make decisions based on incomplete information. No one has a crystal ball that can perfectly forecast the future.
Even worse, our emotions often cloud our judgment and instil feelings of panic and pressure. Our fight or flight instincts kick in and we also struggle to admit we were wrong. While we have made more than our fair share of wrong decisions to sell or hold onto losing stocks, we will review some tips and challenges of deciding when to sell stocks.
Put emotions aside before deciding to sell your stocks
Our emotions are strongest at extremes – the loss of a family member and the birth of a child are two examples. Unfortunately, investment results are major emotional triggers as well. We feel exuberant when our investment doubles in value and we get angry, depressed or even scared to look at our account when our stock prices plunge.
Perhaps the most aggravating feeling is selling a stock at what turns out to be the bottom and watching it shortly after double in value. If only I had held on a little longer!
For better or worse, price volatility is inevitable. Fluctuating stock prices are here to stay and we must learn to cope with them rationally, especially when it comes to selling our stocks.
Warren Buffett’s farm analogy from his 2013 shareholder letter encapsulates the approach towards daily price fluctuations in stocks:
“There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behaviour? If his daily shout-out was ridiculously low and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behaviour of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behaviour of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.”
If we are not careful, we can let the day-to-day noise of the market and swings in stock prices cause us to make short-sighted decisions.
Charles Ellis, a leading American investment consultant, aptly stated, “The average long-term experience in investing is never surprising but the short-term experience is always surprising.”
No one knows what will happen over the next week, month or year and we need to keep that in mind the next time we are tempted to make a short-term trade or listen to a market forecast by some guru.
Many of the market’s short-term swings in price are driven by factors that don’t concern long-term investors and are usually an overreaction to near-term news events. When things are good or bad today, we tend to believe the trend will continue for the foreseeable future. This is one reason why stock market bubbles and busts occur. Stocks may not at all times reflect fundamentals and they are increasingly prone to trading up or down on near-term results rather than their long-term earnings prospects.
For the patient investor, market volatility can bring extraordinary investment opportunities. But many investors cashed out their accounts at the worst possible time acting on fear alone.
We can also get into trouble by being overconfident. As individual investors, we believe that we can manage our money effectively. It can be hard for us to admit when we are wrong and move on to a better idea. Legendary investor George Soros credits almost all of his wealth to being able to change his mind decisively: “I’m only rich because I know when I’m wrong. I basically have survived by recognizing my mistakes.”
We need to take a more fluid approach to selling stocks and be willing to correct investment mistakes as soon as we realize they are wrong instead of letting them balloon into even greater errors.
How often should I sell my stocks?
When deciding to sell a stock, we need to be forward-looking. Many of the reasons why a stock’s price is depressed are obvious in hindsight and we have a tendency to latch onto those factors and even extrapolate them far into the future beyond what is reasonable. Our emotions can cause us to lose focus on the company’s long-term outlook and overly punish it for a single poor quarter of results.
The more often we buy and sell stocks, the more we generally lose. Warren Buffett chimed in on this reality when he said, “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
As human beings, our natural instincts are to take corrective actions when things aren’t going our way. However, this is often the exact wrong thing to do in investing. Buffett has also said that “the stock market is designed to transfer money from the active to the patient.” Worrying less about the market’s daily gyrations and staying patient are important keys but go against our human emotions.
However, we live in a dynamic world and are constantly prone to making investment mistakes. Instead of reacting to near-term changes in price of caving into emotional desires, we can follow a few guidelines when we are thinking about selling a stock. The section given below will discuss four guidelines.
Our four rules for deciding when to sell stocks
Three of our rules for selling a stock are applicable and the fourth rule is primarily relevant for dividend investing.
Sell Rule #1: The company’s long-term earnings power is impaired
Stock prices follow earnings over long time periods. According to Warren Buffett, “Our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.”
Put another way, companies that are able to grow in value over time will ultimately see their stock prices move up with earnings. The number one reason why we sell a stock is if we believe the company’s long-term earnings power has become permanently impaired.
These are some of the hardest judgment calls to make and they can make or break an investment’s return. If it was easy, we would be able to quickly identify and sell value traps while doubling down on high-quality stocks that have been unfairly beaten down.
The best we can do is to try to understand the factors that are hurting the company today. Ask yourself if the reasons for the stock being weak are more likely to be transitory or permanent in nature. Issues such as currency headwinds or sluggish growth in the economy are likely to resolve themselves over the next year or two and could be buying opportunities, whereas changing consumer preferences or new competition could permanently impair a company’s long-term profitability.
Trying to place the factors hurting the company into one of these two buckets (transitory or permanent weakness) can refocus you on the fundamentals and help you better decide if you should sell your stocks or potentially add to your position.
Sell Rule #2: The stock’s valuation has reached excessive levels
If a company’s fundamentals are humming along as we hoped, we prefer to never sell. However, the price of a stock can deviate significantly from its intrinsic value for numerous reasons, many of which tie back to our emotional biases and herd mentality, which create rolling booms and busts. While this is just a general rule of thumb to help us stay aware of valuation risk, it can come into play for our next rule on when to sell stocks.
Sell Rule #3: We have a better investment idea
This is our favourite reason to sell. If a high-quality dividend stock suddenly becomes available at a more attractive price than one of our current holdings, we will consider making a swap.
Sell Rule #4: The safety of the dividend payment is at risk
As conservative dividend growth investors, we understand that a growing dividend is often the sign of a financially healthy and profitable business. Dividends also fund your retirements and passive income needs, so the last thing you ever want to experience is a cut to your dividends.
Many investors will immediately sell a stock after it decides to cut its dividend but you should do your best to get out before the reduction is made. Gauge the risk of a dividend cut by analysing a company’s free cash flow generation, payout ratios, debt levels, recession performance, near-term business trends and more.
Final thoughts
Knowing when to sell a stock is one of the biggest challenges investors face. Our emotions often handicap our ability to think rationally and we find ourselves pursuing short-term income and profit gains far too often – even when we call ourselves long-term investors.
Combating these dangerous tendencies is no easy task but following a simple plan that (1) puts us in an emotionally stable place where we can think rationally and avoid unnecessary trading activity; (2) takes a critical look at the driver’s impacting the stock’s underperformance, classifying them as either temporary or permanent concerns and (3) really commits us to a 10-year investment horizon that can significantly help our cause.