How to know when to sell a stock; 3 reasons to sell
Congratulations, you’ve made it!
The fact that you’re currently reading this indicates that you chose to invest – which in itself is an achievement.
And now that you own stocks, you want to know when to sell the stocks for maximum profit.
Let’s take a look.
Stock selling 101
Warren Buffett, the legendary investor once said – “Our favorite holding period is forever”. Some might make the case that it’s not technically true. Because selling stock is the only way you can realize all of your capital gains. And you’re right. However, what Buffett means to say is not that you should never sell your stock. But more like, you should hold on as long as possible.
Because it has been proven that the stock market appreciates in the long run – the more time you stay invested the more valuable the investments will be.
But there’s a catch here.
The market is rising in value does not mean that all the companies are doing good – more importantly, it does not mean that all companies will rise in value in the long run. Some might just stay the same, where some decrease in value.
The point is, you should know when to sell and when not to sell.
The 3 reasons to sell
Sell the stock if there is no more room for growth
You should ideally sell the stock if the company can’t grow anymore. This would be where the company has reached a saturation point, from which there isn’t room for significant growth. And no significant growth equals no significant earnings and as a result, investors wouldn’t want to pay more for the stock.
To understand whether or not a company can grow more, there are some metrics that you can look at. Market capitalization is one of the most common metrics investors use to identify a stock’s potential for growth. Small-cap companies have a lot of room for growth, whereas a trillion-dollar company can’t grow much. The reason is simple – once you have your revenue in the hundreds of billions of dollars, it’s hard to make money on top of that. For example, Apple – the most valuable company in the world by market cap, had a revenue of $274.52 billion in the financial year 2020.
However, you should not sell off all the large-cap companies, especially not the ones that pay a good dividend– if there isn’t much capital appreciation, the dividend yield should be at least 5-6%. It’s better to trim your position, selling off portions at a time.
Sell the stock when the fundamentals change
When strong fundamentals are the reason you bought the stock in the first place, shouldn’t you sell the stock when the fundamentals change? That raises another question – how do you know whether or not the fundamentals have changed? To find the answer to this question, let’s take a step back and look at what constitutes a company’s fundamentals.
Fundamentals of a company typically include their financial and corporate performance, business model, moat, management, market share, etc. These are pillars on which the whole business is built. So in the event, one of these pillars changes, or in the worst case – ceases to exist, it’d be good to take a second look.
For instance, in the case of airlines, the global pandemic led to a major change in the core of the business – because people stopped flying. Now, some might argue that this is just temporary, and once the restrictions are lifted, everything will be back to normal. But, is that really the case?
Airlines are an industry where even the slightest disruption can cause major problems. Even if the entire population is vaccinated – an event for which we don’t have a timeline, would people go back to traveling the way they used to? Also, business travel is the major source of income for airlines, and that to an extent has been replaced by Zoom.
Keep in mind that not every fundamental change is bad for the company. Some changes can steer the course for the better in companies that are on a downward spiral. This means to say that just because something has changed does not mean you should sell the stock and invest the money elsewhere. More like, take a step back and see how this particular change in the fundamentals might affect the company in the next 5 years. If you feel it’s not the same company that you bought initially and you don’t have faith in the company anymore, it might be a good time to sell.
Sell the stock when you achieve your goal
Every investing plan should have a goal, along with a sound strategy that takes into account your time horizon, risk tolerance, etc. The goal can be anything you want to achieve – retirement, long-term wealth, etc. The more flexible you are with when you want to achieve the goals – the better.
And once you achieve that goal – whatever the goal may be, it might be a good time to sell. Because, at the end of the day, you need to sell your investments to realize the gains. And if you have been reinvesting your dividends, probably you never cashed out – and it might be time for that. You shouldn’t sell when the market is in a downturn, but at the same time, you shouldn’t wait for the market to hit an all-time high. Because in the short term, the market is rarely predictable.
When NOT to sell a stock
Now that you have seen the various instances at which you sell your stock, let’s look at the opposite scenario – when not to sell a stock. And this is perhaps more important than knowing when to sell. In a nutshell, you should never sell your stock for any other reasons than those mentioned above.
For most investors, the number one reason to sell a stock is a price drop. And it is also the number one reason why many investors underperform the market and lose out on the potential market winner. Whenever investors see a dip in the price of the stock they own, investors immediately sell the stock, glad that they managed to mitigate the loss because of their immediate action.
Thanks to those investors, nowadays all it takes is slightly awkward news to get the investors spun into action, sell the stocks and drive the price down. The best example of this is when Zion Williamson’s Nike basketball shoes exploded on national TV. Nike shares fell the next day – they were down 9 percent.
Understand that anything and everything can affect the stock price in the short term – it moves up, down, and sideways. And it’s okay, it’s not a reason to sell the stock. If you look closely, you will find that most of the time, it’s just random market movement – meaning there might not be a specific reason why the stock went down. Sometimes, it seems like it dropped on its own. The point is – don’t sell your potential ten-bagger because it dropped some percent.
Unfortunately, it’s easier said than done. When you are losing money because your stocks are going down, it can be hard not to sell. Emotions are part of human nature and greed and fear may lead to illogical decisions. This is why keeping your emotions in check is important. Whenever you’re faced with a decision to sell or hold the stock, ask yourself – is it emotion or logic that is driving this decision? The human tendency to trust the ‘gut feeling’ or ‘instinct’ might not work in the stock market. Any decision based on gut feelings and instincts likely won’t go well.
A couple of things to keep in mind to avoid such scenarios; do your homework before buying a stock, have an investment strategy in place, and understand that by selling now, you might be missing out on a stock that could potentially take your portfolio through the roof.
The rule of selling
Every investor should understand and accept these facts when investing in the stock market.
You’ll always have some losing stocks
It does not matter how hard you try and how deep you look, you won’t be right all the time. You might have been right about the company’s prospects, but unfortunately, an unforeseen event is all it takes to change everything about a company – but that’s fine. All it takes is a few great stocks in your lifetime to create generational wealth. The 80-20 rule applies to investing as well; 80 percent of your returns will come from 20 percent of your stocks.
It might take a long time
As an investor, you must accept the fact that companies might take years to generate significant returns for the shareholders. The stock can keep going sideways for a long time. There might be several factors that restrain the company from this, it can range anywhere from having a dominant competitor who holds a major portion of market share, to degrowth of the sector. You’ll lose far more money selling too early than you will by buying bad companies.
Take Microsoft for example, from 2002 to 2013, the stock produced returns of merely 13 %. However, from 2013 to 2021 the stock rose a whopping 600%.
Due diligence is a must
If you don’t do due diligence on a particular stock, it’s not an investment, it’s a gamble. And when you gamble with stocks, you might be forced to sell too early or hold on till it’s too late. Hence, you must study the company and its fundamental components before investing in it.
When you buy a stock, you should be prepared to hold it forever. That’s the mentality that gives you substantial returns in the stock market. The next time you think of selling a stock because the stock is down 10 percent, think of the guy who sold his Amazon shares after the dot-com bubble. So make wise investment decisions that are based on logic and facts, not emotions and hype, and sell only when the situation calls for it. Remember, investing is not an exact science, it’s an art.
And if you don’t have a repeatable investing process to help you manage your portfolio in arguably the most uncertain market environment in history, check out our guide on Bear Market Investing Strategies.
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