Aside from the topic of investment analysis, one of the most complicated and difficult to understand parts of investing is the art of selling.
I say "the art of selling" because, in many ways, selling is an art. Experienced investors will know and understand that it is virtually impossible to sell or buy a stock at the right moment. More often than not, after you've sold, the stock price will go higher and after you've purchased, the shares will only fall. But by understanding the fact that you will never be 100% correct in your trading decisions, you can be a better investor.
Difficult to analyze
Selling is a difficult topic to investigate because there is no set structure or preferred method for investors. The Oracle of Omaha Warren Buffett (Trades, Portfolio) is well-known for his ultra-long-term holding periods. When he buys a significant position for the portfolio of Berkshire Hathaway, he does so never intending to sell. This has worked out well for him, but for most investors buying and holding for decades is a risky strategy (unless of course, you are buying Berkshire Hathaway or one of its compounder peers).
The selling process starts right at the beginning of every investment analysis. You're looking to buy a stock trading at a low valuation. Part of the evaluation process will be trying to calculate how much the intrinsic value is. When you know this target, you have a clear objective of when to sell. But what if the company does not hit this target?
In a recent conversation I had with another investor, we discussed the idea of setting a time limit for holding a position. If it does not work out in three years, it is time to sell. This is a very blunt way of looking at possible returns over time. Each year you hold a stock, the opportunity cost of owning the company over anything else increases. But if you believe the stock could be worth 100% more, is a three-year target suitable? Probably not.
A 100% return over three years gives an internal rate of return of 25.9%. In this scenario, if you believe the investment to be worth 100% more than its current level, a four or five-year time horizon could be equally acceptable. A 100% return over five years is still a highly attractive internal rate of return of 14.9%. Four years equals 18.9%.
Why sell if nothing is wrong?
Still, in many ways targeting a return within a set period is a lazy and unpredictable way of investing. Whenever I think about when to sell a stock, I always think back to a famous quote from legendary investor Philip Carret:
"One of the great faults of investment analysts is to try to put limits on what they recommend. They say, for example, 'Here’s a stock selling at $12 [a share]. Sell at $18 a share.' That’s nonsense. If that’s all you expect out of it, leave it alone. If you buy it at $12 and you think it might double, one should feel comfortable in buying it. Probably the greatest performer in recent history is Berkshire Hathaway. [Berkshire Hathaway Inc., based in Omaha, Neb.] I bought the stock about ten years ago at $400. Imagine how I’d feel if I sold it at $800. [It was recently selling at more than $24,000.] Why sell anything unless something goes wrong?"
I mentioned above that buying with the intention of holding forever, is a mistake for most investors. However, it can be argued that buying and holding with the intention of selling at a certain price or after a certain time can be equally as bad.
If there is nothing wrong with the company, and it continues to grow, there is no need to rush to try and exit the position. Of course, to be able to adopt this approach you have to have a rigorous and controlled research process, but that is a discussion for another day.
Disclosure: The author owns shares in Berkshire Hathaway.
