When To Sell
Without a plan, the decision to exit a stock can be a minefield of potential errors
I’m sure we have all seen a version of “if you had bought Apple, Amazon or Infosys, some 30, 20 or 10 years ago.” $1000 dollars would be worth so much that you could live off it.
In my younger naivety, I wondered this out to my boss and he said, think of the times that if you held a stock and it went up and up, how many times in it’s upward journey would you have the urge to sell and how long long could you have resisted that urge. Surely, the desire of cashing out the bounty for a vacation or when the company missed a quarter and the financial press went negative on it, would have made it become harder to hold it.
It really takes ‘diamonds hands’.
There are some obvious behavioral biases that affects this decision:
Loss aversion bias- In order to preserve profits, even if its small, let’s investors to sell their profitable positions prematurely and hold on to losing positions, hoping they bounce back, but can be duds and lead to more losses.
Anchoring bias: Having a pre-determined target, like an investor buys a stock at 50 and waits till it reaches 75 before to sell it without any rationale.
Influenced by media or peers: the decision to exit or sell a stock influenced by outside agents that might have different interests or their own personal biases than our own strategy or preferences.
And I’m sure there are more.
But, how do you guard against these biases and when do you sell?
The first thing is to have a philosophy, strategy or reason why you own a particular stock and have clear reasons why you exit it whether in gain or loss.
Systematic Strategy: This is what Shyam and I do, we design investment strategies where the rules for entry and exiting positions are clearly defined.
We have a pre-determined profit, stop loss, trailing stop loss - stop loss inches higher as stock goes higher or time increases or rebalancing - where we exit a bunch of stocks, often under-preforming ones for fresher candidates.
Some strategies might have a tiny profit target and a wider stop loss and some the other way around. And these entry and exit rules are based on what worked when we tested the strategy in simulation and live modes and have shown to provide an edge.
The clearly defined rules free us from the emotional biases and as long as the strategy is implemented with discipline, where a position is entered and exited as designed and tested, we believe the performance should hold up over a long period of time.
Intrinsic Value: More traditional investors, like to buy a stock when they think it’s undervalued, an investor might do a discounted cash flow analysis and think a stock should trade at-least 30% above it’s current price and buy the stock.
The ideal thing for such an investor to do is sell the stock when it reaches it’s intrinsic value in profit. Or sell it in loss if there is an adverse information that changes her earlier analysis and then she should just sell it whether it’s in loss or little bit of gain.
Following advice: If you bought a stock based on a research report, advice of your investment advisor or recommendation of a friend, who you trust in these matters, then it’s imperative that you exit when that person tells you to.
Sticking to the original reason: Suppose if it was a speculation on quarterly results, then post the results, whether the stock went in your favor or against, you should exit. There is a old joke that you know short term traders are in trouble when they start looking financial statements to reason out holding on to a losing position.
Red flags: If something materially changes about the company significantly that changes everything.
But what if the objective is to hold onto stocks for the long haul, to have stocks that appreciate not by a few percentage points but increase 2x,5x or even 10x, you know the next Amazon. What do you do then? When do you sell?
In that case,
Keep winners and sell losers: Say you identify a portfolio of stocks that seem to have high potential and you know some will end up being duds, others do okay and few will do really great. In such a scenario, it’s always good to exit stocks that are losing money, there could be a pre-determined level where one exits a stock when it goes against you and those freed up funds can be used to enter new position which allows fresh flow of new ideas coming through.
And by keeping the winners you are allowing ideas or stock selection that have been vindicated by the market and likely to continue to outperform and it’s a good reason to continue to be invested to take part in its upward journey.
Sell the winners when it falls: Not when it falls by a minor amount or few percentage points (unless that’s the strategy) but enough to signal a reversal of trend, it maybe -20% from its highs or below its 200 DMA or whatever is suitable. The reversal of trend might indicate that the trajectory of stock has changed and that might be a good time to exit.
Or withstand short term pullbacks and volatility: if the case is that one truly believes that the stock that one is holding a unique company and that any pullbacks are temporary and due to short term nature of the market and exacerbated often due to external factors and over a longer term it will resume its upward trajectory and reach newer highs.
Then, if someone has the ability to hold on, then they should hold onto the stock as long as their belief in the stock holds.
Of course that belief in the stock should be validated by visible evidence that it’s truly a unique company and the company is growing and continuing to grow at a rapid pace, has sustainable and lasting competitive advantages and a focused and competent management.
If those things are true, then don’t sell till you really need the money.
Write it down
The reasons to exit should be written down with the reasons to enter. Here’s where we recommend that all discretionary investors keep an investment journal. Write down 4-5 sentences on why you are entering (hypothesis), what should cause you to exit (violation) and how long are you willing to let it play out (duration.)
Leaders win through logistics. Vision, sure. Strategy, yes. But when you go to war, you need to have both toilet paper and bullets at the right place at the right time. In other words, you must win through superior logistics.
– Tom Peters – Rule #3: Leadership Is Confusing As Hell, Fast Company, March 2001
Think of buy and sell discipline as the logistics of investing. You could be a genius analyst, but if you ignore the “boring” things, you are likely to have mediocre outcomes.
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