Most investing discussions revolve around when to buy a stock. “Which stock should I buy?” is the first question that comes to your mind when you think about investments. But equally important is the question – “When should I sell a stock?”
In this lesson, I try to answer some of the questions around when to sell a stock. Not every selling rule under the sun may be included herein, but I’m sure what you read and see below will still be of some help to you.
Many investors, especially short term traders would agree to the fact about cutting their losses as soon as possible. However, for long term value investors selling a stock as soon as you see red (a price decline) can be a dangerous activity.
Why dangerous? Simply because you lose out on the opportunity of benefiting from any compounding that that stock can achieve over the next 5-10 years, in case the underlying business has such potential.
The way I look at the problem of “when to sell is” that my cost price does not matter when I’m looking to make any sell decisions. What matters is my expectation from the business over the next 10 years or so. If the expectation is still good (of an expanding earning power), even after the rise in stock price in the past, I continue to hold on.
Legendary value investor Phillip Fisher, who had a lot of influence on Warren Buffett’s investment philosophy, had 3 simple rules for selling stocks –
1. Wrong Facts: There are times after a stock is purchased that you realize the facts do not support the supposed rosy reasons of the original purchase. If the purchase thesis was initially built on a shaky foundation, then the shares should be sold. More money is lost by people who’ve held on to bad, losing businesses hoping to get their money back some day.
2. Changing Facts: The facts of the original purchase may have been deemed correct, but facts can change negatively over the passage of time. Management deterioration and/or the exhaustion of growth opportunities are a few reasons why a stock should be sold according to Fisher. You must avoid the commitment bias here.
3. Scarcity of Cash: If there is a shortage of cash available, and if a unique opportunity presents itself, then Fisher advises the sale of other stocks to fund the purchase.
So treat each day you own a stock as the first day of owning that stock. And you should decide to keep owning it, or sell it, depending on what you expect from the business starting that very day and for the next 10 years.
And please do not sell a stock just because…
- It has gone up 2x since your buying price; or
- It has surged 20% in the last one month; or
- You expect a correction and plan to buy the stock again at a lower price.
While making the decision to sell a stock, forget about what you paid for it. This is because what you paid for a stock has no bearing on the future price. Only consider what the approximate intrinsic value is today.
Ask yourself, “If I didn’t have these shares, would these be worth buying now, at today’s price?”
If not, then sell it now. Don’t let your ego ruin your investment returns. You’ve already had it enough!
Similarly when you own a terrific company, you don’t want to sell simply because it is “fairly valued” today. That’s because the company will continue to grow, and its earnings would be materially higher 10, 15, 20 years down the line.
Selling a stock is often an emotional process, perhaps more emotional than buying. This is because after analyzing and holding a stock for some time, we tend to develop an emotional connection with it. However, the stock doesn’t know that you own it, and it will not hold a grudge against you for selling it.
Our investments are about only one thing – the benefit you can derive from them in the future. The past is past. You did what you did, and lost what you lost.
This is one of the most important things I learned from my 2012 interview of Prof. Sanjay Bakshi. He said –
People need a way to de-bias themselves and one good way to do that is to mentally liquidate the portfolio and turn it into cash and then, for each security, ask yourself, “Knowing what I know now, would I buy this stock?”
Often the honest answer would be a most certain “no”. Then the next question you have to face is – “Then why do I own it now?”
It’s not easy to admit our own investing mistakes, simply because we don’t want to convert our paper pain and losses to actual pain and losses. So whatever number of times I may ask you to cut your losses, the truth is that it’s hard to do in practice.
But, as I have personally experienced, once you adopt the practice of mentally liquidating your investments from time to time, you get in the habit of viewing them more rationally.
This way, I’m sure as years pass, you’ll see your performance as an investor improving. Plus, the habit of mentally liquidating your stocks from time to time should liberate you from your past decisions and focus on the future.
Remember – making a selling decision with an eye just on the stock price is a bad idea.
A diagrammatic checklist (see below) will help you understand and retain the ideas that we have discussed in today’s lesson.
P.S. If you wish to study the art and science of picking great stocks, and the process and principles used by some of the world’s best investors, I invite you to look at my premium, online course in Value Investing – Mastermind. Click here to know more.