The Art of Selling Stocks

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.

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Introduction

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.

Important Points

  • 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.

selling-loss-graph

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.

selling-model Click to enlarge

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.

An Example

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.

What happen?

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:

  1. Have your selling strategy written down.
  2. Look at it often.
  3. Make changes as you gain additional insight.
  4. Stick to your selling strategy – no exceptions!

I wish you all the best with your investment endeavors.

Tim du Toit

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The purpose of EuroShareLab is to share knowledge and ideas gained in over 20 years of investing experience and continuous learning to help other self directed investors on their investment journey.

Visit EuroShareLab, browse through past content and sign up for our free weekly newsletter. Do something for your financial future today.

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About OSV Guest Author


This article was written by a Guest Author.To submit a guest post, please contact [email protected]

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  • Ted

    Wow, “I buy more when it goes down 16% then sell it when it goes down 25%, because, hey, you never know, maybe there’s a reason it dropped!”

    Not exactly a genius strategy.

  • http://compoundinglife.com Ken

    Thanks for the article. I agree that one should have selling rules/strategies to guide them and keep them in check. Especially when dealing with a company whose fundamentals have changed or you made an outright mistake in the analysis. However I think picking arbitrary percentage point drops as triggers to action just feeds the “I have to do something” mentality. You are falling for Mr. Market instead of having him serve you.

    If something was a already a good bargain at X and the market sends it down another 25 points, you should probably be selling your more overvalued holdings to take advantage of this opportunity. Assuming you are confident in your analysis.

    Ken’s last blog post..Wesco Financial Annual Meeting Notes

  • http://www.oldschoolvalue.com Jae Jun

    @ Ted
    Although I dont sell based on certain percentage drops, if this model works for the author that’s great. After all the purpose is to not lose money.

    @ Ken
    Good points about Mr Market. All too often, many investors sell once their stock takes a huge drop thinking that something is wrong when it is really just Mr Market playing up.

    Like yourself, if I buy a dollar for 50c and then Mr Market offers it again for 25c, I’m a buyer of course. Will try to get there first in line but I too find myself missing out sometimes over analyzing the situation.

  • Jacob

    Overall, I loved the article. It serves as an eye opener by discussing that we need to be just as focused on selling as we are on buying because all to often people worry about finding that next great stock…well what happens when Mr. Market brings the price back down after all the hype has left? If you had selling rules, then maybe you would have profited a little bit of $$$ when other people were still buying in. That’s part of what I’m taking from this article.

    I agree with his methodology about arbitrarily having percentages of when to buy more and sell more but only when he does an analysis of the recent events that caused the business to fluctuate in price.

    Just my two cents…

  • http://www.oldschoolvalue.com Jae Jun

    Yea, you nailed it Jacob. Buying is the easy half of the equation. Selling is the difficult part which cant be defined as purely science or art but everyone should also have a selling strategy that they stick to just like how we always adhere the margin of safety and circle of competence rule.

  • http://www.eurosharelab.com Tim

    Ted, Ken and Jacob you all raise good points.

    My percentages are arbitrary but they work for me.

    After re-evaluating my analysis I usually increase my position as this is usually en even better price to be getting the investment at.

    I have also learned not to invest a too high a percentage in one name.

    All investments are bets with a certain probability of paying off. What I am trying to do is to limit my losses on bets that are not paying off.

    Tim’s last blog post..9% Euro return from a utility like business

  • http://compoundinglife.com Ken

    @Tim

    If it works for you then thats what is important. My comment about arbitrary trigger points is my personal opinion and thinking for your self is IMO the most important part of any investment strategy.

    @Jacob

    Good point. My personal feeling is that you hold/buy when the stock is undervalued and sell when its at value or overvalued. So if there is alot of hype around a stock and it goes above what you believe the intrinsic value to be then definitely sell. However just because a bargain stock goes up %50 it may still be undervalued. If it is I would usually hold the position and wait however long it takes to for the value to be reflected in the price. Of course this assumes regular analysis to make sure the value is still there.

    But if you are attempting to trade on movement and not based on a margin of safety then it is probably better to have rules like “sell when it reaches %50″ because you only barometer is the stock price.

    Thanks all for a great discussion.

    Ken’s last blog post..Wesco Financial Annual Meeting Notes

  • http://ragnarisapirate.blogspot.com jeff

    granted, your goal is to not lose money, but still, if the market is manic depressive (which it often is), and a stock goes down 30%, then up 100%, you have lost out.

    for example, I remember buying into Finish Line a while back (when they made the stupid offer to buy up another retailer)… the shares plummeted from my initial purchase- well over 60%. However, I held out, and eventually sold my position at a hefty gain. Point being, selling stocks, due to an arbitrary loss figure, will only increase your transaction costs, and lessen your chances of holding on to a great winner (provided that you have done your research)

    All I am getting at, is that in times like these, a few percentage points that are shaved off the share price of a security are pretty meaningless; look at the price volatility in SNS!

    jeff’s last blog post..Book Review of Distress Investing: Principles and Technique

  • DV

    I agree in principal, knowing when to sell is very important, I recently took some losses crystallizing them, one of which I let go too far after management issued more shares at half the going market price…! I should have exited earlier… Needless to say I won’t be touching that one again. Don’t necessarily agree with your exit strategy, but at least you have one.. which is better than most people. You can control risk by either putting smaller positions on or using stop losses. I prefer the 1st option as I usually invest in higher risk small cap value companies.

  • DV

    For example I bought GSIG a couple of years ago at $0.81c as a NCAV stock, it then went into chapter 11 bankruptcy reemerged after a reverse stock split relisted on Nasdaq and my average cost was $2.57, it is now trading around $11.00 I sold enough to get my original money back at around $10.80 and now have free shares up 360%.. I think it will eventually go to $15-16 but now I am already looking at others… in fact just bought BSPM Biostar Pharmaceuticals yesterday for $1.05 with great fundamentals (and technical breakout) looking for very significant upside, but only with a tiny position size as volatility is huge! And I don’t even live in the US…

  • Mike

    Great article Tim. Selling is given less focus I believe, as most investors focus on when to buy and often overlook when to sell either to take gains/cut losses which is what makes this article a gem. I have recently subscribed to EuroShare Lab and have found Tim’s enhanced investment checklist (PDF) very useful so OSV subscribers I would recommend subscribing to EuroShare Lab’s newsletter as well!

    Following are some notes from investing books I have read on the topic of selling and thought I would share them with you here:

    The first two have a focus on technical side which is why I only included these two as we are long-term investors and they basically sum up “the trend is your friend” thesis:

    How I made $2,000,000 In The Stock Market – Nicolas Darvas
    “I did not have any reason to sell a rising stock. I would just continue to jog along the trailing my stop-loss behind me. As the trend increased, I would buy more. If the trend reversed? I would, as ever, flee like a disturbed burglar.”

    How To Trade In Stocks – Jesse Livemore
    “If the stock you traded is going the opposite direction than you expected-sell it quickly. It means your judgment was wrong-cut your losses quickly”

    The Motley Fool Investment Workbook – David and Tom Gardner
    “If it waddles like a dog, pants like a dog, and begs for food at dinner like one, it most likely is in fact a dog. Sell it!”

    I use an excel spreadsheet I created around the dividend yield as a signal of undervalue/overvalue (in addition to other metrics of course) as taught by Weiss & Lowe.
    Dividends Don’t Lie – Geraldine Weiss/Janet Lowe
    “To buy in an undervalued area and to sell in an overvalued are is about the best that any investor can hope to do. Perhaps no one ever will fully master the market. As the saying goes…just when we think we have the key, someone changes the lock.”

    Investors Business Daily’s 20 Rules for Investment Success:
    #20: Do a post-analysis of buys and sells.

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