Know When to Fold'em: When Is the Right Time to Sell a Stock?

There's one word in every stock market movie ever made that's never uttered in a normal tone of voice. Never merely said, but rather shouted.

That word is SELL!

Indeed, no other word in the financial lexicon is so often associated with market uncertainty, investor fear, or in the worst case, outright panic. Truthfully, I can't recall a single film in which the protagonist calmly decides to sell based on reasoned analysis.

Of course, that's the case in movies because it makes for stronger plots - ones propelled by high drama and intense emotions. But all too often, it's much the same in real life.

And it shouldn't be.

Nine Good Reasons for Selling a Stock

Your reasons for selling a stock should be just as clear, just as rational and based just as your reasons for buying that stock in the first place. Fear, though often cited (along with greed) as a driving force in market price movements, should never play a role.

Unfortunately, rules for selling stocks are much less clearly defined than guidelines for purchasing them. However, the following list offers some insights that should help you make more reasoned decisions regarding when to sell, enhancing your market profits in the process:

1. Sell when the reason you purchased the stock in the first place no longer applies. This is the primary rule for selling cited by almost every great investor - from Warren Buffett and Peter Lynch to George Soros and Sir John Templeton.

If you would no longer buy the stock given its current fundamentals, it's probably time to sell. A variety of news items and financial indicators, most of which you can find in the company's own releases and reports, can help you identify such a shift. Some of these include:

  • A slowing in the rate of growth in earnings or earnings per share.
  • A downturn in overall sales or revenues despite a healthy economy or strong industry performance.
  • A narrowing of the cash-flow ratio, because less money is coming in or the company's expenses are increasing - or both. Increasing inventories and rising receivables relative to sales may also be signs of impending cash-flow problems. (Changes in cash flow can be a particularly valuable warning signal for developmental-stage companies that don't yet have a proven record of profits.)
  • A decline in the rate of return on the company's invested capital. Warren Buffett considers return on invested capital "insurance" toward future growth in that it provides extra money for the company to reinvest in maintaining its edge over competitors.
  • A sharp decline in research spending, indicating the company probably won't be introducing new products in the near future.
  • Where applicable, the failure of anticipated new products to receive regulatory approval.
  • Ouster of existing top managers because of internal conflicts, or the appointment of new management that quickly announces plans to take the company in a new direction. (This may not necessarily be bad, but if you bought the stock because you liked the company's old direction, you probably won't want to go along for the ride.)

2. Sell if the stock's not keeping pace with the overall market or its specific sector. Sometimes a company can show continued growth in earnings and revenue, but still be headed for trouble. If the market is rallying or the industry is strong but your stock is trading flat, or losing ground, it may be a sign that the company has as-yet-unrecognized problems or is suffering from a competitive disadvantage that will likely get worse.

3. Sell if the stock far outpaces the overall market or the rest of its sector. This is simply another way of saying the stock has become overvalued - that its price has increased far faster than the growth in its fundamentals. An excessive price-to-earnings (P/E) ratio relative to its own past P/E or the current P/E of other similar companies may indicate the stock has been driven up by unrealistic expectations and could be headed for a fall.

4. Sell at least some of your shares if a "hot" stock begins to dominate your portfolio. Without getting into a discussion of asset allocation or portfolio rebalancing, it's not a good idea to have a single position make up too large a percentage of your holdings. If that happens because of a huge run-up in the price of one stock, reduce your risk by taking partial profits and shifting the money into other issues (or asset classes) that have both good fundamentals and reasonable prices, giving them more room to advance.

5. Sell if the long-term trend the company benefits from shifts in a different direction or dies entirely. Changes in economic, technological or cultural trends can kill a company in just a few years - or even months. For example, holding on to the stock of even the best typewriter maker would have been senseless in the 1970s when the entire world was transitioning first to word processors and computers. If a company isn't prepared to introduce new products and shift ahead of the trend, it's time to sell that stock and move into the shares of a company that will.

6. Sell when the overall economic trend turns downward or the prospects for a given sector go sour. Using an extension of the example in No. 5, it makes no sense to hold stock in even the best computer company if the economy is so bad that businesses are folding or unable to make new equipment purchases, putting the brakes on computer sales throughout the market. As we've seen the past couple of years, even top companies suffer during such times - and their stock prices fall as a result.

Having said that, most of the experts advise against trying to "time the market," selling based solely on short-term indicators or other technical factors rather than fundamental changes in market or stock valuations. Such trading action is speculation rather than investing, says Peter Lynch.

"Far more money has been lost by investors preparing for corrections or trying to anticipate (them) than has been lost in corrections themselves," says Lynch.

7. Sell when your stop is triggered. Warren Buffett lists as his No. 1 investing rule: "Don't lose money." While it's virtually impossible to follow that rule in every instance, you can ensure that any losses you do suffer will be small by religiously entering stop orders on every stock you purchase - and moving that stop point higher as the stock's price advances (a so-called "trailing" stop). Your own risk tolerances and investment objectives will dictate the levels at which you place your stops, but limiting a possible loss to 20% is a fairly standard guideline.

8. Sell to take advantage of a better opportunity. Although few of the world's most successful investors advocate active trading, preferring to seek out long-term-value, there may be times when you uncover an outstanding stock but lack the funds to buy it. In such instances, there's nothing wrong with culling a weaker performer from your portfolio to raise the needed capital for the purchase. Be sure, however, to consider transaction costs and the tax consequences of the sale, which could offset the added potential you see in the new stock.

9. Sell when everyone else is buying. The "contrarian" approach applies just as strongly to stock sales as to stock purchases. When the market has made a major advance and everyone is certain it's going to continue, frantically buying for fear of missing out on even greater gains ahead, that's the time to start evaluating which of your stocks are most overvalued and preparing to sell. Every bull market of the past has ended and you can be just as sure every bull market of the future will, too. When you start to think that things will be different this time around, that's the ideal time to sell.

Also Consider...

The nine guidelines just presented are primarily linked to company specifics, market conditions or the emotions of other investors, but you'll also likely make some sell decisions based on more personal reasons. Some situations where that might be the case include:

1. You've reached your goal. If your stock investments were targeted toward a specific objective - say financing a child's college education, the purchase of a home or early retirement - you'll need to sell once the time comes to implement that goal. The key is to systematically liquidate the necessary stocks, starting with the weaker performers or those offering the lowest tax consequences, while letting your stronger holdings continue to build equity.

2. You unexpectedly need some cash. Health problems, an accident, a death in the family, storm damages - the list of potential events suddenly demanding money is endless - and selling a stock, especially one that is underperforming, is a good way to meet that expense. Better still, however, is to inventory your personal financial situation prior to such an emergency and make sure you have a cash reserve sufficient to allow you to avoid such forced liquidations.

3. Your personal values change - or a company whose stock you own changes its practices. For many investors, environmental, social, ethical and moral standards outweigh potential profits, no matter how large they may be. If a shift in company policies conflicts with your personal values, that's ample reason to sell the stock, regardless of its fundamentals or prospects.

4. Your nerves can't handle it. At the beginning of this article, I said sell decisions should be based on reason and logic, not emotions. Carefully evaluating fundamentals and diligently using stops should aid you in that respect, but sometimes they're not enough. Some stocks - even quality ones - can be highly volatile without triggering your stop, rattling your nerves and keeping you awake at night. If that's the case, sell the offender and switch to a stock that will appreciate in a pattern you're more comfortable with.

Obviously, over the course of your investing career, you'll find other reasons to sell - both market driven and personal. However, if you gauge each situation against the guideposts just presented, it should help ease your uncertainty about making these critical sell decisions - decisions that, when made at the right time, will vastly improve your investment returns.

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