After my post on when to sell stocks last week, we have a guest post from fellow reader Tim du Toit, the editor of EuroShareLab, to discuss his methods of selling. Since selling is a difficult aspect of investing, I encourage you to read the following post by Tim.
I always thought of myself as a long term buy and hold investor. Buying good companies and holding through thick and thin thinking that overall my investment performance will be acceptable. But looking at my portfolio over time I realized that I developed the tendency of selling winners and hanging onto losers. Try as I may, I found it really hard to rationally break away from this tendency.
After a lot of research I developed a strict selling strategy which has helped me a lot and I hope it helps you too. If nothing else I hope this article prompts you to think about your approach to selling and how it can be improved.
- You should have a selling strategy
- You should have it written down
- You must review it regularly
- You have to force yourself to follow it
Why is it important to limit losses?
Limiting losses is very important as the gains required to recover the loss grows exponentially as the loss gets larger.
The following table and graph show the relationship between a loss and the recovery visually.
Whatever approach you take to selling, this is the most important principle to bear in mind, irrespective of how positive you are on the recovery probability when it comes to the losing investment in your portfolio.
Behavioral aspect of selling
Fear and regret play a large role in investors failing to sell a stock that has declined. Sometimes when a stock falls, it’s a great opportunity to increase the investment at an even more attractive price. But in cases where investors have made an obvious mistake, and logically should sell immediately, behavioral research shows that they will often hang on, thus suffering even greater losses.
Why is this?
By selling, they have permanently locked in the loss, and then have to confront the pain and regret of having made a bad investment, including the potential embarrassment of disclosing the loss to others.
Somehow, in our minds, we think that our ownership of something increases its value. This is incorrect. For example, just after placing bets, punters at the racetrack become much more confident about their horse’s chance of winning the race. Similarly, lottery ticket buyers tend to buy more frequently if they are allowed to choose their own numbers. Investing in shares is no different.
So what can we do to avoid costly and annoying errors?
- Approach investment decisions from as neutral a position as possible
- Ignore all sunk costs by ignoring the cost of the investment when reviewing your portfolio
- Accept it as inevitable that you will make mistakes in your buying decisions
- You will face tremendous pressure that will tempt you to rationalize your mistakes and not correct them
- You will tend to protect the status quo by inventing new reasons to hold on to a bad investment
- This will be especially true when your original buying decision is known to many other people who are important to you, as it will hurt you to acknowledge this to them, and to yourself.
- It will be difficult for you to correct the mistake because you will attach more importance to saving face by appearing to be consistent with your past commitments.
- Don’t overvalue your current positions. Pretend that you don’t own them, and ask, “If I didn’t own this stock today, would I buy it?” If the answer is no, you should think hard about selling.
- Don’t compound past mistakes for fear of embarrassment. In the end, the best advice is to learn from mistakes and move on.
Selling Stocks to Realize a Gain
1. Movement of the share in the ranking
If you buy stocks based on a ranking or a mechanical strategy, such as a low price to earnings ratio, low price to book ratio, or high dividend yield, the movement of the stock from cheap to expensive through the ranking can be used to determine the selling point.
2. When your premise is fulfilled
This is what it is all about – selecting a share because of a reasoned, well-thought investment premise, and things work out exactly like you expected, or better. When this happens you have every right to feel confident and take your well earned profits.
3. After a substantial rise in price
Another reason for selling is when you think the stock has become more valuable than it should be. Unfortunately, for many of us, the realization that a stock price has increased too much comes long after the price has already peaked and started to fall.
4. When it doubles
An old adage in the market is that you should sell half your holdings when a stock doubles. This is a purely emotional reason to sell a stock. It allows you to feel like you have received all of your money back and that the money you now have in the share is pure profit or “house money”. The concept of “house money” is purely emotional as all the money, including the gain, is always all yours.
Selling Stocks to Limit a Loss
1. Your reason for making the investment
Once you have done your homework on a company, write down your concise reason for buying.
Should you use this selling strategy, you may want to implement a strict rule that if you were wrong about the reason for investing, you should exit the position with no questions asked. Never invent new reasons to hold a position when the original reasons are no longer applicable.
Holding onto a position simply to recover your initial capital is usually a recipe for even greater losses.
2. Leave emotions out of it
Should it happen that management really makes you angry, you may want to put the investment away for a while and not do anything. Try not to take action just because of your emotions.
If you take action because of an emotional reaction, it is likely that a lot of other investors are thinking exactly the same. This means that everyone is abandoning the investment at exactly the same time. I have found it better to wait a while, even if I am still angry.
3. When your nerves can’t take it any more
Have you ever bought a stock that has taken you for an emotional roller-coaster ride? Instead of increasing in value the price dips and bounces every day. If holding the stock makes you so uncomfortable that you can’t sleep and you only worry about how much money you have lost or made in a single day, you are being distracted.
4. Percentage drop in price
This strategy is the simplest of all, but also much more difficult to implement than it looks. Sell after a fixed percentage decline in price. This level can be set by looking at the recovery table mentioned above, or can arbitrarily be set according your pain threshold.
My Approach (Tim’s)
Below is a diagram of my approach to selling. It’s a combination of the many considerations mentioned above.
The loss and gain levels are arbitrary, but they are ones I feel comfortable with. You can use it as a basis to build your own selling strategy. Even though I have developed it and feel comfortable with the arguments and values, I still find it difficult to stick to. The toughest decision is to sell according to the model when I think the share is down due to a negative day for the stock market overall, or negative industry news. The most frustrating is when I did not sell at a 25% loss and the loss then increased to 33% or more.
How the Stock Selling Model Works
Loss of more than 16%
If the share price declines more than 16%, I first ask if I have already added to the position. If not, I redo the analysis. If the business has not deteriorated in one of the five factors mentioned, then I buy more after selling the position to make use of any tax losses. The position is never a hold – either I buy more as the investment has become more compelling, or if it has not, I sell.
Should I have increased my position, the loss on the new total position would have decreased as my average purchase price has declined.
Should my loss again exceed 16% after I have bought more shares, I ask a friend or fellow investor to redo the analysis. I use this objective review to determine if I have missed anything in my analysis. Should the independent evaluation come to the conclusion that it is a good investment, I may buy more or I may just hold, depending on the size of the position in my portfolio.
Loss of more than 25%
In order for a loss to exceed 25%, I would have had to go though my own, and an independent, review of the position when the loss got to 16%. At this point I cut my losses. I may be wrong in selling but I can always buy the shares again.
Selling at this point has enabled me to get out of a position where it has later shown that something was happening in the market or with the company, that I did not understand.
Gain of more than 50%
Should my gain on the investment exceed 50%, I also review the position. If the investment was a “Cigar butt”, a description Benjamin Graham gave to cheap, bad quality businesses, I exit the position as the lowest risk gains have been made.
If the investment is a high quality business, I determine if the gain has been purely price-based with no change in the earnings of the business. Should the former be the case, I may sell right away, or may still hold if the valuation is lower than the market or peer group based on price to earnings ratio, for example.
Should the earnings of the investment have increased along with the price, I will hold the shares.
As you can see, my approach to selling is mainly sticking to the “rules”, but it allows some decision freedom. What I really try to stick to is the hard rule of selling out at a 25% loss.
About a month after I bought Dell Inc., the share price fell 17%.
The following day I looked at my financial analysis and made sure there were no updated financial or recent news I was not aware of. I found nothing, apart from uncertainty around worldwide computer shipments in the coming year. I added to my position.
This lowered my loss to 11%, as my average purchase price was lowered by the additional shares. About six weeks later my loss again exceeded 16%.
This time I asked a friend to work through my financial analysis to see if he found the company an attractive investment. Apart from a few points he also thought it an attractive investment. I decided to hold the position and not buy additional shares.
Three weeks later my loss on Dell exceeded 25% and I sold the position. From what I could gather the share price decline was caused by weak sales results by Lenovo Group, one of Dell’s competitors. Having sold the share I was in the position to objectively and unemotionally evaluate what I wanted to do from there going forward – repurchase the share after waiting for the situation to stabilize, or look for alternative investments.
Dell’s share price recovered slightly after I sold, but subsequently went on to lose a further 20%.
The sale thus had a good outcome, but even if the share had recovered I would have been pleased as it limited my losses and gave me complete emotional freedom to evaluate my options.
Summary and Conclusion
The goal of this article is to show that it is important to think about your selling strategy in advance of making your investments, and to make it clear that selling is a lot more difficult than it looks.
To summarize the most important points in this article:
- Have your selling strategy written down.
- Look at it often.
- Make changes as you gain additional insight.
- Stick to your selling strategy – no exceptions!