Never mind what to buy do you know when to sell?

Have you ever seen a book written on how and when to sell stocks? Only when I 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 didn’t 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 hard to 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 must have a selling strategy

Have it written down

Review it regularly

Force yourself to follow it

The above points may seem stupid or irrational but believe me they are not. If you don’t do this you won’t follow your own strategy for reasons I will explain below.

I tried the ?do not worry I will follow the strategy? approach, it doesn’t work. Once you have formulated your strategy you have to brain-wash yourself with it or you won’t follow it.

Why is it important to limit losses?

Limiting losses is important because the increase needed to recover the loss grows exponentially as it gets bigger.

This is best shown 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 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 very fast. 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 big role in investors not selling a stock that has fallen. 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 a mistake, and you should sell, behavioural research shows that you will hang on, suffering even bigger loss.

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.

Also our minds 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 looking at your portfolio.

Accept the fact that you will make mistakes in your buying decisions.

Know that you will face a lot of pressure that will tempt you to rationalise your mistakes and not correct them.

Know that you will try to protect a bad decision by inventing new reasons to hold it.

Know that it will be more difficult to sell when your buy decision is known to a lot of people who are important to you. It will hurt you to admit 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.

Don’t overvalue your current investments. Pretend 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 must sell.

Don?t add to past mistakes for fear of embarrassment. Learn from mistakes and move on.

Here are a few strategies on how you can improve your selling decisions.

Selling to realise a gain

Movement of the share in the ranking

If you invest 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.

When your idea is fulfilled

This is what it is all about – selecting a share because of a reasoned investment idea, and things work out exactly like you expected, or better. When this happens 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 strategy – sell the investment.

When it doubles

An old market rule is that you should sell half your investment when the price doubles. This is an emotional reason for selling. It allows you to feel like you have gotten all of your money back and that the money you now have in the invested is pure profit or “house money”.

The idea of “house money” is purely emotional as all the money, including the gain, is all yours.

My approach

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 20%.

As soon as a position in this part of my portfolio falls 20% from its high it is sold. No questions asked. This allows me to profit from further price increases while at the same time getting out of the position as soon as it starts to fall.

If you decide on following this strategy it’s 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 will see this investment 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 your reason for buying. If you are wrong about your reason for buying you must exit the investment with no questions asked. Never invent new reasons to hold a position when the original reasons no longer apply.

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 going up 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. 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 above table or can be set by your pain threshold.

My approach

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. I realised that the more rules my strategy had 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 falls more that 20% from its highest price since I bought it (trailing stop loss) I sell. I know this in controversial but it works for me.

I implemented this strategy after looking at all my investments over a number of years and I saw that my best investments did well right from the start. The faster you can sell losing investments the faster the money can be invested in another possible winner.