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When it comes to investing, there are two important decisions you need to make – buy and sell decisions. More often than not, selling is actually more difficult than buying. Today, we will talk about when you should sell your stocks.
But first, let’s look at why sometimes it’s harder to make selling decisions than buying decisions.
According to Investopedia, here’s the definition of endowment effect.
“The endowment effect describes a circumstance in which an individual values something which they already own more than something which they do not yet own.”
Because of endowment effect, we have the tendency to hold on to stocks even if the stocks are no longer fit with our investment goals or they are losing stocks.
It becomes harder to make the right decision when there is an emotional attachment.
What is confirmation bias?
A psychological phenomenon that explains why people tend to seek out information that confirms their existing opinions and overlook or ignore information that refutes their beliefs.
How does it apply to investing?
Investors made an investment decision based on their analysis and opinion. Even if the investment turns out to be a bad idea, they have the tendency to look for information that supports their original buying decision and ignore information that tells them that they should sell the stocks.
Research has shown that the pain of loss is two times stronger than the joy of gain. To avoid feeling the pain of loss, we sell away our winners early and hold on to our losing stocks.
Have you ever sold off your winning stocks just to watch it make new high later on?
Because you don’t want to lose back your gains, you quickly sell your winning stock and take profits.
Have you ever refused to sell your losing stocks because you wanted to wait for it to bounce back to your break-even price?
Because you want to avoid the pain of losing money. You would even convince yourself that it’s just paper loss.
But let’s not kid ourselves.
A paper loss is still a loss.
To become a successful investor, we have to be aware of our behavioral biases.
When To Sell Your Stocks?
So, when should you sell your stocks?
Here are 7 indicators to consider:
- Need money for non-investment purposes
Maybe you need money to buy a new home or get a car.
Or maybe you’ve lost your job and need money to pay bills.
Of course, there are many other possible reasons why you might need the money.
When this happens, you can always sell your stocks and get back your money.
- Reason for buying is no longer there
When you invest in the stock, you have your reasons for investing in it.
What are your reasons?
Are they still valid?
These are some questions you need to ask yourself.
If you are a value investor, you bought the stock because it’s a good business at a cheap price at the time of purchase.
But now, is it still a good business?
Their future growth is still promising?
If the fundamentals of the company has changed in a negative way, then it’s time to re-evaluate it and decide whether or not to sell.
- There are significantly better investment opportunities
Are there much better investment opportunities?
Better investment opportunity means that you can get much higher returns on your money for the same amount of risk you take.
If such opportunity presents itself, it’s a no brainer to switch.
- Portfolio re-balancing
Over time, your portfolio can become skewed.
So, how does it happen?
Let’s look at one example.
Let say, based on your investment objective, you bought a good mix of 40% growth stocks and 60% dividend stocks for your portfolio.
But, your growth stocks appreciated in price at a much faster pace than dividend stocks.
Now, your portfolio mix is 60% growth stocks and 40% dividend stocks.
It’s no longer aligned with your investment objective.
So, you have to re-balance your portfolio to achieve a portfolio mix of 40% growth stocks and 60% dividend stocks.
How do you re-balance your portfolio?
Sell some of your growth stocks and buy more of dividend stocks.
Do this until you have the 40/60 growth-stock-and-dividend-stock mix.
- Stocks have become overvalued
Warren Buffett once said his favorite holding period is forever.
“When we find a great company, we want to own it forever.”
That’s the most ideal situation.
But, the world is never ideal.
Even Warren Buffett has sold off his stocks before.
When you bought your stock, the stock could be undervalued.
However, are you going to sell or keep holding it after the stock has become overvalued?
Before that, let’s talk about how you can tell if a stock is overvalued?
One simple way is to just look at its P/E multiple. A multiple of 40 and above should be considered overvalued in the value investors’ eyes.
But of course, the stock price could still keep going up despite a very high P/E multiple.
Because the investors’ perception of the stock could be still positive and they think the price could go even higher.
As value investors, you should not speculate which direction the price will go.
Instead, you should make your decision based on your value investing principles – Buy Undervalued & Sell Overvalued
- Stock has hit your profit target/stop-loss
Before you invest in the stock, you should already have a pre-determined profit target and stop-loss.
Having a profit and loss plan in place stops you from making wrong emotional decisions.
For example, your profit target could be a 50% increase in price.
Once your profit target has been hit, it is time to sell your stocks and take profit.
- Stock market crashing
Stock market goes in cycles.
Every cycle is normally 7 to 8 years.
When stock market crashes, investors become irrational and they oversell fundamentally good companies out of fear.
Back in 2008, it would be smart to sell all your stocks early and keep cash on hand.
With all the cash, you can scoop up all the good undervalued stocks when market bottoms out.
For example, google share price dropped to its lowest at about $130 during the crash.
Within one, its share price doubled.
In the next 8 years, its share price increased by almost 7 times.
The moral of the story is that you want to have the cash to invest when great investment opportunity presents itself.