One of the biggest challenges investors face is knowing when to sell a stock.
Deciding to buy a stock is relatively easy. There are many different reasons why investors would buy a stock. It could be because it looks cheap or because it has the potential to change the world.
They could just be hoping it will go up, and they will be able to sell it to another investor or the company will be taken over (some investors might argue this is not actually investing, but speculation).
Deciding when to sell an investment is far more complicated. If it is a mistake, it is difficult to admit making one and sell up in order to move on.
If the investment has been a success, it's difficult to say when it will be fully valued. And if it's a buy-and-hold play, it's difficult to say if the stock has become overvalued and if it will struggle to grow into its current valuation.
One approach investors can use to overcome the issue of when to sell a successful investment is to use a valuation framework, which is continually updated based on the company's fundamentals. This requires a lot of time and effort, and many investors might not be willing to revisit the thesis continually.
But this approach does have drawbacks. The problem with selling any investment is that it will usually need to be replaced. Investors need to consider this when trying to establish whether or not it is a good time to sell.
Finding a new investment
In 1996, at Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) annual shareholder meeting, Warren Buffett (Trades, Portfolio) explained this conundrum when discussing if he would ever sell holdings when they reached egregious valuations:
"You can really hold them at extraordinary levels if it's too hard to find --you're not going to find businesses that are as good. So then you have to say, 'Am I going to get a chance to buy back the same business at a lot lower price? Or am I going to buy something that's almost as good at a lot lower price?' We don't think we're very good at doing that. We'd rather just sit and hold the business and pretend the stock market doesn't exist."
This is something investors need to consider when selling an investment. What's the opportunity cost of selling that investment? Every action we take as investors increases the chance of something going wrong.
For example, let's say there's always a 50-50 chance of picking a good investment. For every winning stock, there's going to be a loser as well.
In this simplistic example, there's no point selling a successful investment when there is a 50% chance that the next investment will end up costing you money.
That being said, it may be sensible to sell an investment if it no longer offers the kind of returns one might be seeking or its business model has changed so much, its potential has diminished significantly.
There's no formula an investor can use to work out if it is time to sell an investment. However, one can reduce the risk of something going wrong with research and using probabilities. All we can do is try to swing the odds of success in our favor.
Buffett tries to do this by sitting on stocks and ignoring the market. That may be a suitable approach for many other investors as well. Still, if one does have to sell a holding, it is important to evaluate the opportunity cost of doing so and the probabilities of success versus failure in another investment.