When Should I Sell a Stock?

The answer depends on human behaviour, investment styles, and your personal goals.

Ian Tam, CFA 23 February, 2022 | 10:03PM
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Road Divergence

The age-old adage of ‘buy low, sell high’ is often used as a sarcastic answer to those seeking advice on stock investing. Of course, if we could all do this then there wouldn’t be a need for a stock market. Having the discipline to be able to sell a stock when the appropriate conditions are met is truly one of the hardest things about investing. Why is it so hard, though?

Our Behaviour Works Against Us

People are generally susceptible to having biases of all different types. Oftentimes, these biases mean we end up making bad financial decisions. As the proverb goes, “to err is human; to forgive, divine.” Unfortunately, to err in investing might not be as easily forgiven in terms of reaching your financial goals. Looking inwards to recognize some of the biases that go into your investment decisions, and circumvent them by objectively comparing facts, is often a useful exercise before making a trade decision.

For example, as a stock investor, you will inevitably run up against a market crash. A common bias known as ‘loss aversion’ might cause an investor to sell positions during a crash and crystalize losses, while losing out on the recovery. Another common bias is known as ‘confirmation bias’, is where an investor might seek to look for information that confirms their view or opinion, perhaps weighting it more heavily than information that contradicts said view. This, of course might sway an investor into holding onto a stock for too long.

In short, biases are not your friends in investing. The first step in recognizing biases is an important one for a disciplined investor. After that, it is useful to recognize how you invest.  

There are Various Approaches to Investing

There is a smorgasbord of approaches when it comes to stock investing. Understanding the investment style that is most intuitive to you will help you define a template or game plan on evaluating buying and selling opportunities. Though not an exhaustive list, here are a three core styles:

1. Value Investing:Akin to Morningstar’s approach in rating stocks, value investors attempt to assign a ‘fair value’ to a stock, often based on a projection of future cash flows, then using a discounted cash flow model to estimate what the stock should be worth today. For value investors, a reasonable time to sell is when a stock’s price reaches or nears the fair value estimate.

Not by coincidence, this is exactly how the Morningstar Star Rating for stocks works. An undervalued company is awarded 5 stars, a fairly value company is awarded 3 stars, and an overvalued company is given 1 star.

Value investors can also use valuation ratios like Price to Earnings, Price to Sales, etc. as a measure to determine whether a stock is trading at a reasonable multiple compared to others in the index, or a specific sector or industry. In this case, investors might consider selling if a stock’s multiple are much higher than similar companies, or a broader universe like an index.

2.  Growth Investing: Growth investors tend to look for opportunities where there is a potential for fast growth in earnings for a company. The polar opposite of a value investor, growth investors couldn’t care less what a company is worth today, but rather focus on a company’s ability to produce earnings in the future.

Broadly speaking, the growth style has been in heavy favor over the last decade given the heavy run-up of the technology sector, where growth stocks often appear. Here, investors might look to a company’s historical growth in earnings, analyst estimate sentiment, and historical profitability as a yardstick for measuring whether the company’s current growth trajectory continues to line up with expectations. When fundamental growth slows, perhaps as announced through a missed earnings report or a downward trend in earnings, growth investors might consider letting go of a growth stock.

3. Momentum Investing & Technical Analysis: Like church and state, momentum investing is the polar opposite of fundamental investing (which entails both growth and value). Here, investors tend to follow trends in stock prices – rooted in the theory that the market is efficient, and all information is quickly reflected into a stock’s price. Momentum investors typically rely on signals from the market indicating that a stock’s price has broken whatever trend it was on before. As an example, when the 50-day moving average of a stock’s price dips below the 200-day moving average, momentum investors might read this as a trend reversal, given that more recent stock prices are lower than they were in the more distant past.

It’s worthwhile noting that momentum investing is not for the faint of heart, requiring lots of monitoring, and typically requiring active trading in a portfolio.  

Have a Game Plan

Whatever style (or combination of styles) is being employed; the key here is to go into an investment position with a game plan. It’s often useful to think about whether the conditions that drove you to purchase a stock still persist today. If they don’t, then get out. Of course, this is much easier said than done, but doing so consistently over time will certainly afford you better results than flying by the seat of your pants. Leveraging points of reference through a spreadsheet, financial software, or even pen and paper are useful tools to ensure that you are making objective comparisons on a regular basis.

Life Tends to Come in the Way

Of course, the other reason to sell out of any investment is when your life circumstances change. For example, if you require the money to purchase a home, or to start enjoying retirement, you’ll need to sell. It is worthwhile to think about future life changes – whether at hand, or years into the future – when deciding on what stocks to buy.

Stocks inherently come with more upside potential and more risks than bonds. Lining up your asset allocation (mix between stocks and bonds) to your risk profile and investment time horizon is of vital importance, to avoid having to sell out of a position at a loss only to find that you can’t meet your financial goals.

 

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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 

 

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