How to be better at selling stocks
There is plenty of advice around about buying stocks, but not so much about when you should sell. John Stepek explains the two key things to know about selling stocks.
Markets are somewhat unsettled as we start 2022.
So what better time to turn to that question which has vexed investors through the ages: when should you sell a stock?
You should never sell an asset just because the price has moved
As I’ve commented before, there’s plenty of advice out there on how to buy a stock. But there’s not so much on the other side of the trade: how to sell well.
Howard Marks of Oaktree Capital, a highly-respected credit investor, has just put out a new memo discussing the role of selling in the investment process. He concludes: “there are two main reasons why people sell investments: because they’re up and because they’re down”.
Those are both bad ideas. If you sell purely because “no one ever went broke taking a profit”, then you may well miss out on even more gains.
Perhaps even more importantly, watching a stock you sold continue to shoot up is at least as psychologically painful as watching one you hold continue to fall. Few things are more likely to lead you to make emotional decisions in an effort to recoup your foregone gains.
If you sell purely because you can’t stand the pain of seeing a 20% loss in your portfolio, you run the risk of selling a perfectly sound company during a period of panic. Watching it recover will give you the same horrible sensation already outlined above.
In short, selling purely because the price has moved relative to where you bought an asset is a mistake. You need a better reason to sell than just “it’s up” or “it’s down”.
It’s worth noting by the way, that this is not a problem that afflicts only private investors like you and I. One recent interesting survey which I wrote up last year found that fund managers are much worse at selling than they are at buying.
So how can you get better at it? To me, there are two key aspects to improving your selling process.
1. You have to know why you bought in the first place
The foundation of your selling process is laid when you buy the stock (or any other asset). You should know why you are buying an asset. If you do, then you’ll have a much easier time of knowing if it’s time to sell.
Let’s take two extremes: day traders, who buy and sell several times a day; and long-term growth investors, who want to hold out for the ten-baggers in the market.
If you’re a day trader, you are trying to time fluctuations in the market. This is high-risk, very difficult, and not to be recommended. The tiny minority who are successful will lay out the parameters of the trade before they embark on it. They know when they’re going to buy, and they know when they’re going to sell.
(This is why traders use technical analysis. You might think that drawing lines on charts is mumbo-jumbo, but what else are you going to rely on to map out scenarios for a 24-hour trade – a balance sheet?!)
At the other end of the scale, I’ve just re-read Peter Lynch’s One Up on Wall Street (I thoroughly recommend it, it’s one of those older investment books which is still very much worth a read, particularly for beginners). Lynch was on the hunt for 10-baggers – companies where you can grow your original investment 10-fold.
That only happens if you have the nerve to hold a stock after the value of your holding has doubled. And then doubled again. And then doubled again. And then gone up some more.
If you hope to have any chance of holding onto a share while it racks up those sorts of gains, all the while terrified that you might lose them, you need to be sure of your thesis. Which means you need to have stated it – in writing – before you ever bought the stock.
So that’s your first rule of selling well. Know why you bought the asset. If you’re a trader (I’d suggest you don’t be, but I’m not your dad), then you need a trading plan that you stick to.
If you’re a long-term investor, you should have an investment journal in which you write down your rationale for buying. If that hasn’t changed, don’t sell (unless you have decided there are better uses for the cash, though you have to be cautious there, as we’ll get to next).
2. Don’t be a forced seller
The other rule of selling well is that you have to sell by choice. If you sell because you need to raise cash in a hurry, that makes you a forced seller. That’s never a good position to be in, regardless of whether you make a profit or loss.
To my mind, there are two ways to be a forced seller. One is obvious and easily avoided by a sensible investor. This is where you have to sell an asset because you misjudged your liquidity needs – it’s the end of the month, you need to pay the mortgage or a big tax bill, and there’s no more cash in the bank.
If this happens to you, you need to take a much closer look at how you’re managing your finances. If you need to sell long-term assets to pay off short-term bills, you’re under-earning or over-spending. It’s redundant to say, you should avoid being in this position.
However, there’s another more insidious way to become a forced seller. That’s when you spot an opportunity you want to take advantage of, but you lack the liquid resources to do so. So you feel you have to sell an existing holding to raise cash to fund the new idea.
This is not a good position to be in. When you’re looking to sell because you’ve found an exciting new opportunity, your judgement is already clouded. You’re focusing on the “new thing”, and all the “old things” in your portfolio look dull by comparison.
Now, clearly very few people have the resources just to buy every asset they think might be attractive. I’d argue that the key here is to make sure that a certain proportion of your portfolio is always liquid.
If you are reviewing your portfolio (say once a month, depending on how active an investor your are) and you find that you need to top up your cash levels, you should be doing it without a “hot” new opportunity in mind. That way you’ll take a more sober approach to deciding which holdings to prune.
Long story short: keep the head. Don’t rush into an investment. Make sure you have good reasons to buy. If you do that, you’ll know whether you have good reason to sell.
By the way, all of this is fundamentally why markets are not efficient – a sufficient number of people just cannot be bothered doing their homework on one or both sides of this transaction. That creates an opportunity for the diligent.