There is substantial body of literature and published opinion on the art of selling stocks. I do not believe my contribution to be unique, comprehensive, nor intrinsically right but see it as more of a hodgepodge of both study and experience that, at least, makes a little sense to me. The following details the basic guideposts I use when facing the sell decision.
There are three basic times to sell. The first two are the easiest, while the third I will elaborate on in detail in this piece. The first one occurs when the investment has been made originally on the basis of a misvaluation (of course what investments are not!) and the company invested in is not believed to possess any substantial long-run, fundamental competitive advantages. These situations often take the form of discounts to tangible assets or book value. When the misvaluation corrects, the stock should be sold, plain and simple. What I call “trading rules” – allowing stocks to run above the misvaluation level on the basis of momentum – can very well have their place here and, for the record, have worked well for my clients; but I would advise the investor to define his/her rules very specifically in advance (e.g. need make a new high within 90 days) and to stick to the definition.
The second time to sell is simply when a better idea comes along. I would warn here only that a considerable margin of safety should be employed in one’s definition of a “better idea” so as to not cause undue damage to the portfolio directly in terms of transaction fees and taxes and, even more destructive long-run, to the investor’s psychology indirectly in terms of mistake agonizing and its potential compounding.
The third time to sell is the most difficult in my opinion – it is when we must face up to a mistake: the business should never have been bought in the first place, or the situation has changed and the investment is simply no longer viable. I have created a four-square to help better understand the emotions at work in these sell situations. The four-square attempts to assess the investor’s psychological state given the results of a mistake-in-question stock’s “performance” six months into the future and the investor’s decision whether to sell or hold it. It assumes that the stock in question is under duress in both the marketplace (i.e. its price has been falling) and in the investor’s mind.
Six months into the future
Was cheap, recovers
Falls further
Sell
Could be kicking self a little if acted emotionally, fearfully
Pretty good; rewarded for admitting an error
Hold
What to do now? Sell or wait some more (assuming misvaluation not corrected)
Pretty bad, victim of hope most likely
The “bad” boxes in the above are obviously selling when the recovery occurs or holding when it does not. What can we learn from these boxes or, more specifically, what kinds of thinking and emotions lead to these kinds of mistakes? The mistake of the sell, recovery box is to purge simply to purge (as if by selling we can trick ourselves into believing the mistake never happened in the first place); however, and this is important, if a sale is made, the stock goes up, but the sale was made confidently after a rational review, we should not fret. This is simply the best we can do; it is necessary to admit that we will be wrong and destroy capital from time to time. The hold, falls box can be a worse error really. It is often the error of holding for hope. Selling to purge is not good on its face; but, in general, taking a loss, not being afraid to capitulate and admit error is not the end of the world. At the least, it is action and it is action you can learn from. Holding for hope, on the other hand, is inaction. Never make this mistake. If it becomes clear that a thesis review is necessary, do it dispassionately. If the thesis is bust, and the idea no longer works, hoping for a better price is simply never a viable option.
The answer, as usual, is to be rational or, at least, be as rational as you can. Selling to sell does not make sense nor definitely does holding for hope. What does rationality entail when it comes to investigating whether or not an investment was and is a mistake? I would offer these guidelines:
1) Review the thesis accordingly: is it “big-picture” violated or are the struggles of the business temporary or overblown by the market? If the “big-picture” has been violated, the first sell will be the best sell: believe in this or you may find yourself holding for hope.
2) Remove the emotion: the thesis need be reviewed coldly and on the basis of facts. There is simply no place for anguish, fear, or hope.
3) Write down the new thesis or sell it: after the review, after the emotion has been removed, the decision is either to sell or hold. The review will yield the answer. If there is a reason to hold, make ceratin a new thesis is drafted that is both clear and compelling.
There are three basic times to sell. The first two are the easiest, while the third I will elaborate on in detail in this piece. The first one occurs when the investment has been made originally on the basis of a misvaluation (of course what investments are not!) and the company invested in is not believed to possess any substantial long-run, fundamental competitive advantages. These situations often take the form of discounts to tangible assets or book value. When the misvaluation corrects, the stock should be sold, plain and simple. What I call “trading rules” – allowing stocks to run above the misvaluation level on the basis of momentum – can very well have their place here and, for the record, have worked well for my clients; but I would advise the investor to define his/her rules very specifically in advance (e.g. need make a new high within 90 days) and to stick to the definition.
The second time to sell is simply when a better idea comes along. I would warn here only that a considerable margin of safety should be employed in one’s definition of a “better idea” so as to not cause undue damage to the portfolio directly in terms of transaction fees and taxes and, even more destructive long-run, to the investor’s psychology indirectly in terms of mistake agonizing and its potential compounding.
The third time to sell is the most difficult in my opinion – it is when we must face up to a mistake: the business should never have been bought in the first place, or the situation has changed and the investment is simply no longer viable. I have created a four-square to help better understand the emotions at work in these sell situations. The four-square attempts to assess the investor’s psychological state given the results of a mistake-in-question stock’s “performance” six months into the future and the investor’s decision whether to sell or hold it. It assumes that the stock in question is under duress in both the marketplace (i.e. its price has been falling) and in the investor’s mind.
Six months into the future
Was cheap, recovers
Falls further
Sell
Could be kicking self a little if acted emotionally, fearfully
Pretty good; rewarded for admitting an error
Hold
What to do now? Sell or wait some more (assuming misvaluation not corrected)
Pretty bad, victim of hope most likely
The “bad” boxes in the above are obviously selling when the recovery occurs or holding when it does not. What can we learn from these boxes or, more specifically, what kinds of thinking and emotions lead to these kinds of mistakes? The mistake of the sell, recovery box is to purge simply to purge (as if by selling we can trick ourselves into believing the mistake never happened in the first place); however, and this is important, if a sale is made, the stock goes up, but the sale was made confidently after a rational review, we should not fret. This is simply the best we can do; it is necessary to admit that we will be wrong and destroy capital from time to time. The hold, falls box can be a worse error really. It is often the error of holding for hope. Selling to purge is not good on its face; but, in general, taking a loss, not being afraid to capitulate and admit error is not the end of the world. At the least, it is action and it is action you can learn from. Holding for hope, on the other hand, is inaction. Never make this mistake. If it becomes clear that a thesis review is necessary, do it dispassionately. If the thesis is bust, and the idea no longer works, hoping for a better price is simply never a viable option.
The answer, as usual, is to be rational or, at least, be as rational as you can. Selling to sell does not make sense nor definitely does holding for hope. What does rationality entail when it comes to investigating whether or not an investment was and is a mistake? I would offer these guidelines:
1) Review the thesis accordingly: is it “big-picture” violated or are the struggles of the business temporary or overblown by the market? If the “big-picture” has been violated, the first sell will be the best sell: believe in this or you may find yourself holding for hope.
2) Remove the emotion: the thesis need be reviewed coldly and on the basis of facts. There is simply no place for anguish, fear, or hope.
3) Write down the new thesis or sell it: after the review, after the emotion has been removed, the decision is either to sell or hold. The review will yield the answer. If there is a reason to hold, make ceratin a new thesis is drafted that is both clear and compelling.
