"I made my fortune by selling too early," said US financier and speculator Bernard Baruch. With stockmarkets around the world on a tear since March, plenty of investors must be wondering whether it's time to follow Baruch's example and get out while the going's good. So how do you know when it's time to sell a share?
Why losses are hard to recover
There's plenty of advice around about what shares to buy and when, but far less on when you should sell your shares. But selling is a vital skill to master. Why? Because losses are very hard to recover the numbers are against you all the way. For example, if you pay £1,000 for some shares, which then drop by 25% to £750, you need them to rise by a third just to get back to evens. If the same shares had fallen in half, you would need them to double. In other words, losses are disproportionately tricky to recover.
And watch out for 'geometric averaging'. Say you invest £1,000 in year one. You make 25% on that, then 25% the year after, but suffer a 50% loss the next year. The simple average return is 0% (25+25-50)/3. But you won't have £1,000 at the end. That's because after one year your £1,000 will have grown to £1,250. Assuming it stays invested, a year later it'll have grown to £1,563 (£1,000 x 1.25 x 1.25). But the 50% loss then slashes that to £781. So avoiding losses is vital and the best way to do so is by knowing why you bought in the first place.
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Know why you bought
If you took a punt on a company you knew next to nothing about, and by some miracle the stock has risen sharply, then sell now and be grateful. A lucky £500 profit may buy as much beer as a £500 skilful one, but luck doesn't last. A much better approach is to keep a note of the criteria you applied to buying and react to changes before a share tumbles.
Three sell signals
Many investors use fundamental analysis (key ratios, such as price-to-earnings and price-to-book) and a slice of judgement (the brand is good, the new management team is strong) to spot a buy. Fine, but once you've bought, you need to keep an eye out for signs that the stock is no longer worth holding on to. Classic red flags include earnings no longer growing, top management leaving or, in some sectors such as pharmaceuticals, a lack of new products or product approvals.
But don't stop there monitor half-yearly or quarterly updates. Watch out for asset 'impairment' write-downs. Acquisitive firms in sectors such as telecoms are especially vulnerable. Rapid growth often results in companies overpaying for rivals. Any dip in activity forces management to come clean on just how badly they overpaid, which means profits suffer.
Next, a few quick checks that growth isn't out of control. Is operating profit (mid-way down the profit and loss account) growing much faster than operating cash flow (at the top of the note that supports a cash flow statement)? Are either stock or receivables ('debtors') rising much faster than sales? These are unsustainable trends beyond the short term and so they're useful early warning signs to watch for.
Let's say you've picked your four favourite sectors and bought two stocks in each, spending £100 in each one. One of your biotech stocks races ahead and rises to £300 while the rest perform more modestly and rise by £25. Time to rebalance. If your original aim was to spread your risk roughly equally over eight shares, sell, say, £175 of your biotech holding (to reduce it to £125) so that what's left is still an eighth of the total. Never forget that a paper profit is just a promise cash in the bank is a fact.
Hitting price targets
If constant rebalancing, according to portfolio weighting, sounds like hard work, then apply a simpler price target. Many investors will ruthlessly dump a stock that drops, say 25%, but should just as ruthlessly take profits when a share rises. However, it's always tempting and often good sense to let a strong winner run. So how can you balance the two?
One good option is a trailing stop. Basic stop-losses are instructions to your broker to sell if a share drops by say 25%. Fine, but what about a share that's rising? Say you buy Vodafone shares for 140p and set a stop-loss 25% below that price (around 105p), but then Vodafone rises to 160p. Here's the rub. Leave your standard stop-loss at 105p and it won't be triggered unless the share falls over 34%. Ideally, you want the 25% stop-loss price moved up to nearer 120p. Trailing stops do this they follow your share as it rises, taking the stop-loss price up too.
Unfortunately, not many brokers offer them. Self-trade will let you set relatively small stop limits as part of their standard deal charge. Barclays and Fidelity will allow you to set bigger ones, but you need to refresh them every 30 days.
However, for regular traders, says InvestmentU's Alex Green, there's another option. At Tradestops.com you can enter the stocks you own (up to 50, listed on the three biggest US exchanges, plus London and Toronto), the price you paid and the percentage trailing stop you want to apply. Tradestops will then alert you (via your email or mobile phone) when a limit is breached.
A stopped stock can be replaced with another up to the 50 limit and there's no time expiry on the service. It won't sell your stocks for you that's still your job via your broker. But that at least gives you the chance to review each stop before it is activated. The service costs $7.95 a month or $79.50 a year, and there is a 30-day free trial.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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