If you’re like many investors, you spend a great deal of time deciding what to buy. While studying what to buy, you should consider when the best time to sell that stock would be. It might be surprising to learn that some successful investors tend to know when they will sell a stock even before they place their buy orders.
This may seem to run counter to Warren Buffett’s advice that selling should be relatively rare. Buy and hold proponents often point to Buffett’s famous quote that “our favorite holding period is forever” as proof that long-term investing is the best strategy. This might be true if you are Warren Buffett but the truth is that none of us are Warren Buffett. Another truth is that even Warren Buffett sells stocks.
In 2016, we know that Buffett sold 100% of his positions in AT&T and Precision Castparts. He also sold more than half of his holdings in Procter & Gamble and Liberty Media and more than a quarter of his position in Wal-Mart. There are dozens of smaller sells listed in his regulatory filings. Buffett is most likely selling because he has found better opportunities elsewhere or he believes these stocks are fully valued at their present prices and offer limited upside. While Buffett’s favorite holding period is forever, he doesn’t hold most of his positions forever.
Buffett’s teacher, Ben Graham, advocated buying stocks when they are undervalued and selling when the stock traded at fair value. This required calculating the stock’s fair value and, in effect, knowing when you would sell before you bought. It was a purely mathematical approach that used value rather than knowledge about the company to decide when to buy and sell. This approach could work well for investors in the current market, just as it worked for investors more than fifty years ago.
To develop a selling discipline, it is useful to have a buying discipline as most investors do. There are thousands of reasons to buy a stock. You could buy a stock when it is undervalued based on its price-to-earnings (P/E) ratio or when its dividend yield is high or when it sells for less than its book value. There are also valid reasons to buy based on technical analysis, such as buying when a stock rises above a moving average. You may notice that each of these buy rules has a sell rule built in – you would sell when the buy rule is no longer true. If you bought because the dividend yield was 20% above its long-term average, you could sell when the yield is 20% below its long-term average. This is one approach to selling and it is the essence of the selling discipline followed by Peter Lynch.
Peter Lynch managed the Fidelity Magellan Fund from 1977 until his retirement in 1990. Over that time, Lynch delivered average annual gains of 29.2% as the fund grew from a few hundred million dollars to the world’s largest mutual fund at the time. Lynch wrote that he required analysts to present buy ideas on index cards. The reason to buy needed to fit on one side of a standard index card. He would then know the stock should be sold when that condition was no longer true. If an analyst said to buy a stock because the company was introducing a new product that would boost sales and profits, Lynch would know to sell if the product was introduced and sales began to flatten.
Under Lynch’s approach, it was okay to reevaluate a stock. In fact, he encouraged that. He reviewed all of his holdings and would incorporate current events into the analysis. If there was a new reason to own the stock, he would continue holding. But Lynch never hesitated to sell when the story changed. If fundamentals deteriorated, he sold. This was often how he dealt with losing positions. Lynch knew he could always buy a stock back later if he was wrong, but he also understood he could never fully recover from a large loss.
The math of large losses can help investors understand how devastating large losses are. Some investors choose to ignore price declines insisting they are long-term investors and it’s just a paper loss until they sell. The chart of Transocean (NYSE: RIG) below shows what can happen to long-term investors.
Investors tend to become excited about large gains that occur after a steep drop. Earlier this year, RIG rallied more than 66% but even after the gain, investors are still 80% below the stock’s 2011 highs. Celebrating a 66% gain doesn’t change the fact that a $1,000 investment has fallen to less than $200.
Many readers will think they would have bought on the decline and missed the worst of the selloff but, of course, there is no way to know when the decline is over. The next chart shows investors who bought in late-2013, after a decline of almost 50% in RIG, still lost 80% of their investment.
The math of large losses can be described as horrifying. If you lose 90% on an investment, you need to gain 900% to break even. Investors need to ask themselves how likely a 900% gain is, especially in a stock that has fallen 90% since they bought it. It is unlikely they will recover their losses quickly. If they recover, it will take years while possibly missing out on other gains.
The best way to avoid a 90% loss is to sell losing positions before they lose that much. A simple stop loss strategy can be used to accomplish this. With a stop loss, you sell if prices fall below a certain price. For the most successful investors, there are no questions at that point — if the price reaches that predetermined level, they sell because they are disciplined. Stop levels can be based on a percentage of your entry price. If you are a short-term trader, it could make sense to sell if the stock price falls by 8-10%. Many investors use stops of 20-30%. Others set a step price for each position based on the chart pattern, deciding to sell if the price falls below an important support level.
Other investors use a time stop, selling if the stock hasn’t delivered a minimum profit in a set amount of time. A time stop could require selling after two years if the stock hasn’t beaten the market over that time. This approach avoids holding onto stocks that are “dead money” and accepts the fact that time is important to creating wealth. Holding stocks that lag the market could lead to underperforming the market and that prevents investors from accumulating wealth.
These ideas could help investors with selling losers but it is also important to sell winners. Returning to Lynch’s philosophy, you could sell a winner when the reason for buying no longer applies. Maybe a company stops introducing new products and transitions from the growth stage of the business life cycle to the mature stage where growth and stock price gains typically slow. If you bought the stock for growth, that would be the time to sell.
Ben Graham’s approach can also help determine when to sell winners. When a stock trades at its fair value it is time to sell. Technical analysis can also help. If the stock is overbought on a monthly chart it could be time to sell. There are many reasons to sell a winner and take profits.
When deciding to sell, investors should be looking at what to buy. Ideally, they can immediately reinvest their profits into a new stock. The new stock should have a larger potential return on investment than the old stock does. In this analysis, it’s important to look at the future returns rather than the past. There is no reason to hold a stock just because it gained 1,000% in the past. Decisions to hold need to be based on the future potential rather than the past.
Once investors understand the importance of selling both winners and losers, they are truly ready to beat the market.