Have you ever seen a book written on how to sell stocks?
Only when I consciously set out looking for one did I find one or two. It was a bit like looking for a needle in a haystack full of books on how and when to buy.
Before I go on let me ask you.
Have you ever given the selling of investments any thought, or better still developed a selling strategy?
I also did not until I looked at my buy and sell decisions over a number of years and realised that I made the classic investment mistakes of selling winners too early and hanging onto losers with the hope that they will recover.
Try as I may, I found it really hard to rationally break away from this tendency.
After a lot of research I developed a strict selling strategy which has substantially improved my returns. And I think it will help you too.
It has helped me to hold winners and sell losing investments quickly and easily.
What is really important is that:
- You should have a selling strategy
- You should have it written down
- You must review it regularly
- You have to force yourself to follow it
The above points may seem trivial or irrational but believe me they are not. If you do not do this you will not follow your own strategy for reasons I will explain below.
I can tell you honestly I tried the “do not worry I will follow the strategy” approach, it simply does not work.
Once you have formulated your strategy you have to basically indoctrinate yourself with it or you will not follow it.
But first some background information.
Why is it important to limit losses?
Limiting losses is very important as the increase needed to recover from a loss grows exponentially as the loss gets bigger.
This is best illustrated with the following table:
The table shows the return you have to generate (column 2) to recover from the loss (column 1) on your investment.
A 5% loss is still relatively easy to recover from but if you suffer a 20% loss you need a return 1.3 times (column 3) the loss to recover your invested capital.
It gets worse.
Should you suffer a 60% loss you need a return 150% or 2.5 times the loss to recover your capital.
Whatever approach you take to selling, this is the most important point to keep in mind, irrespective of how positive you are on the recovery of the losing investment.
Behavioural aspect of selling
Fear and regret play a large role in investors failing to sell a stock that has declined.
Sometimes when a stock falls, it’s a great opportunity to increase your investment at an even more attractive price.
But in cases where you have made an obvious mistake, and logically should sell immediately, behavioural research shows that you will often hang on, suffering even greater losses.
Why is this?
By selling, you have permanently locked in the loss, and you then have to confront the pain and regret of having made a bad investment, including the potential embarrassment of disclosing the loss to others.
Somehow, in our minds, we think that our ownership of something increases its value.
This is a BIG mistake.
For example, just after placing bets, punters at the racetrack become much more confident about their horse’s chance of winning the race. Similarly, lottery ticket buyers tend to buy more frequently if they are allowed to choose their own numbers. You as an equity investor are no different.
So what can you avoid these costly and annoying errors?
Here are a few suggestions:
- Approach investment decisions from as neutral a position as possible.
- Ignore all sunk costs by ignoring the cost of the investment when reviewing your portfolio.
- Accept it as inevitable that you will make mistakes in your buying decisions.
- Realise that you will face tremendous pressure that will tempt you to rationalise your mistakes and not correct them.
- Realise that you will tend to protect the status quo by inventing new reasons to hold on to a bad investment.
- Be aware that it will be especially difficult to sell when your original buying decision is known to many other people who are important to you, as it will hurt you to acknowledge this to them, and to yourself. It will be difficult for you to correct the mistake because you will attach more importance to saving face by appearing to be consistent with your past commitments.
It is thus very important that you do not overvalue your current investments. Pretend that you don’t own them, and ask, “If I didn’t own this company today, would I buy it?” If the answer is no, you should sell.
Don’t compound past mistakes for fear of embarrassment. In the end, the best advice is to learn from mistakes and move on.
In the next part I will a few strategies as to how you can improve your selling decision making.
Selling to realise a gain
Movement of the share in the ranking
If you buy stocks based on a ranking or use a mechanical strategy, such as a low price to earnings ratio, low price to book ratio, or high dividend yield, the movement of the stock from cheap to expensive through the ranking can be used to determine the selling point.
For example if you buy the 10 highest ranked companies, should a company in your portfolio not be in the top 10 or 20 after a year, the position is sold.
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When your premise is fulfilled
This is what it is all about – selecting a share because of a reasoned investment premise, and things work out exactly like you expected, or better.
When this happens you have every right to feel pleased and take your well earned profits.
After a substantial rise in price
Another reason for selling is when you think the stock has become more valuable than it should really be.
If it has become overvalued in terms of your investment criteria sell the investment and reinvest in an undervalued company.
When it doubles
An old adage in the market is that you should sell half your holdings when a stock doubles. This is a purely emotional reason for selling.
It allows you to feel like you have received all of your money back and that the money you now have in the invested is pure profit or “house money”.
The concept of “house money” is purely emotional as all the money, including the gain, is all yours.
To overcome my tendency to sell winning investments too soon I now move all my investments that I think have become overvalued to a separate part of my portfolio where I follow a strict training stop loss system of 15%.
As soon as a position in this part of my portfolio declines 15% from its high it is sold. No questions asked.
This allows me to participate in further upward movements in the stock price while at the same time getting out of the position as soon as it starts to decline.
Should you decide on following this strategy I have found it very important to move the overvalued investments to a separate part of my portfolio (in my case a separate part of my portfolio spreadsheet).
If not you may think of the position as part of your normal portfolio and may ignore the trailing stop loss.
Selling to limit a loss
Your reason for making the investment
Once you have done your homework on a company, write down a short reason for buying.
If you were wrong about your reason for investing, you should exit the investment with no questions asked.
Never invent new reasons to hold a position when the original reasons are no longer applicable.
Holding onto a position simply to recover your initial capital is usually a recipe for even greater losses.
When your cannot take it any more
Have you ever bought a stock that has taken you for an emotional roller-coaster ride?
Instead of increasing in value the price dips and bounces every day.
If holding the stock makes you so uncomfortable that you can’t sleep and you only worry about how much money you have lost or made in a single day, you are being distracted.
In this case it’s much better to sell the investment and invest in a something less volatile.
Percentage drop in price
This strategy is the simplest of all, but also much more difficult to implement than it looks.
Sell after a fixed percentage decline in price. This level can be set by looking at the table shown above, or can arbitrarily be determined according your pain threshold.
In the past I have had elaborate selling strategies based on certain points where I will buy more and if the investment declines even more in price I sell out completely.
What I realised that the more intricate my strategy was the more difficult it was to follow and the easier it was for me to rationalise not selling a losing investment.
I have since made my selling strategy as simple as possible and I urge you to do the same.
If an investment declined more that 20% from the price I paid for it I sell.
I know this in controversial but it works for me.
As I mentioned above, I implemented this strategy after analysing my portfolio positions over a number of years and I learned that my best investments tend to perform well right from the start.
The quicker you can sell losing investments the sooner the funds can be invested in another possible winner.
The most important points in this article are:
- Formulate a strategy
- Have your selling strategy written down.
- Look at it often.
- Make changes as you gain additional insight.
- Stick to it – no exceptions!