Deciding when to sell a stock has to be one of the hardest investment decisions to make. Compared to buying, when it is easy to make a decision based on the current stock price and your estimate of intrinsic value for a business, you need to consider a wider range of factors when establishing whether or not it is a good time to sell a security.
Figuring out when to sell
The primary problem investors face when selling, above all else, is knowing precisely what an investment is worth.
Establishing the intrinsic value of a security is a hit-or-miss process. That's why the best investors advocate using a wide margin of safety when analyzing whether or not it is a good time to buy a stock.
However, when it is time to sell, the situation is entirely different. Here's how Seth Klarman (Trades, Portfolio) explained the problem in his book, "The Margin of Safety:"
"Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision."
Some investors try and overcome this problem by putting in place specific rules on when to buy and sell, such as a set value before entering the trade, or a specific price-book ratio or price-earnings ratio. Others use percentage gains or losses.
In his book, Klarman argued that all of these methods are wrong. Instead, investors should approach the question of when to sell with the following mentality: "all investments are for sale at the right price."
He went on to explain that decisions to sell must be based on underlying business value, just like decisions to buy. Investors should also consider the alternative opportunities available:
"Exactly when to sell—or buy— depends on the alternative opportunities that are available. Should you hold for partial or complete value realization, for example? It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains. By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available."
Like so many questions in investing, there is no one set answer to this problem. Nevertheless, Klarman stated in his book that the best way to determine when to sell is to consider the underlying intrinsic value - not just of the company you own, but of the other available opportunities as well.
If the stock you own is trading at what you perceive to be a 10% discount to your intrinsic value estimate, but another company is trading at a discount of 30%, it could be better to take your profits with the first opportunity and invest in the other offer before it disappears. Waiting for the last drop of profit could mean you miss out on the next opportunity.
On that note, I'm going to end this article with some of the rhetorical questions Klarman used to sum up his views in the book:
"If selling still seems difficult for investors who follow a value-investment philosophy, I offer the following rhetorical questions: If you haven't bought based upon underlying value, how do you decide when to sell? If you are speculating in securities trading above underlying value, when do you take a profit or cut your losses? Do you have any guide other than "how they are acting," which is really no guide at all?"
Disclosure: The author owns no share mentioned.
Read more here:
- Ben Graham on Market Fluctuations
- Benjamin Graham: How to Find Bargain Stocks
- Are Berkshire Hathaway's Shares Cheap?
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