We have all been there. One of our stocks is down over 30% from where we bought it, and we know it is time to make a tough decision – should I sell my stock, or is it time to double down?
Alternatively, it can be just as hard to decide what to do when some investments are up significantly, causing us to wonder if we should sell our stocks to lock in some profits.
Selling stocks is hard for numerous reasons. We are almost always forced to make decisions based on incomplete information. No one has a crystal ball that can perfectly forecast the future, which can make us feel paralyzed to act.
Even worse, our emotions often cloud our judgment and instill feelings of panic and pressure. Our fight or flight instincts kick in, and we also struggle to admit we were wrong and take a loss. Paralysis is a common outcome, and our losers can quickly become even bigger drags on performance.
While we have made more than our fair share of wrong decisions to sell or hold onto losing stocks, we will review some tips we have learned over the years and share some advice from investment pros that have experienced the same challenges of deciding when to sell stocks.
Put Emotions Aside Before Deciding to Sell Your Stocks
Our emotions are strongest at extremes – the loss of a family member and the birth of a child are two examples.
Unfortunately, investment results are major emotional triggers as well. We feel exuberant when our investment doubles in value, and we get angry, depressed or even scared to look at our account when our stock prices plunge.
Perhaps the most aggravating feeling is selling a stock at what turns out to be the bottom and watching it shortly after double in value. If only I had held on a little longer!
For better or worse, price volatility is as inevitable as it is unpleasant. Fluctuating stock prices are here to stay, and we must learn to cope with them rationally, especially when it comes to debating if we should sell our stocks.
Warren Buffett’s farm analogy from his 2013 shareholder letter is one of my favorite lessons regarding how we should respond to daily price fluctuations in our stocks:
“There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is.
After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior?
If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.”
If we are not careful, we can let the day-to-day noise of the market and swings in stock prices cause us to make short-sighted decisions.
Charles Ellis, a leading American investment consultant, aptly stated, “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.”
No one knows what will happen over the next week, month, or year, and we need to keep that in mind the next time we are tempted to make a short-term trade or listen to a market forecast by some guru.
Many of the market’s short-term swings in price are driven by factors that don’t concern long-term investors and are usually an overreaction to near-term news events. Bill Gates noted our nearsighted bias when he stated the following:
“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.”
When things are good or bad today, we tend to believe the trend will continue for the foreseeable future. This is one reason why stock market bubbles and busts occur. Stocks don’t always reflect fundamentals, and they are increasingly prone to trading up or down on near-term results rather than their long-term earnings prospects.
For the patient investor, these events can bring extraordinary investment opportunities. When the tech bubble burst in 2000-2001 and the financial crisis erupted in 2008-2009, many blue chip dividend stocks were hammered along with the rest of the market.
Was this the time to sell your stocks? Of course not (remember Buffett’s farm analogy), but many investors cashed out their accounts at the worst possible time acting on fear alone.
We can also get into trouble by being overconfident. As individual investors, we believe that we can manage our money effectively. It can be hard for us to admit when we are wrong and move on to a better idea.
Legendary investor George Soros credits almost all of his wealth to being able to change his mind decisively:
“I’m only rich because I know when I’m wrong. I basically have survived by recognizing my mistakes. I very often used to get backaches due to the fact that I was wrong. Whenever you are wrong you have to fight or take flight. When I made the decision, the backache went away.”
We need to take a more fluid approach to selling stocks and be willing to correct investment mistakes as soon as we realize they are wrong instead of letting them balloon into even greater errors.
Even the best investors in the world are wrong over 40% of the time, and it is unreasonable to believe we can fare any better. Finding and correcting our mistakes as soon as possible is important, but too much trading activity is almost never a good thing either.
How Often Should I Sell My Stocks?
In an interview conducted by the American Association of Individual Investors, Professor Terrance Odean studied a data set of trading records from more than 80,000 individual investors and found that:
“On average, the stocks that these investors bought went on to underperform the stocks they sold. If an investor sold one stock and bought another, odds were that the one sold subsequently outperformed the one he bought.”
When deciding to sell a stock, we need to be forward-looking. Many of the reasons why a stock’s price is depressed are obvious in hindsight, and we have a tendency to latch onto those factors and even extrapolate them far into the future beyond what is reasonable. Our emotions can cause us to lose focus on the company’s long-term outlook and overly punish it for a single poor quarter of results.
Professor Brad Barber also weighed in after investigating 66,000 trading accounts. He grouped these investors into five sections based on how frequently they traded. His research showed that “the buy-and-hold investors, after trading costs, were outperforming the most active investors by about six or seven percentage points a year.”
The chart below is from his study and shows a clear correlation between portfolio turnover (i.e. how frequently you buy and sell stocks) and investment returns. Investors who trade the most saw the lowest returns.
Source: American Association of Individual Investors
The more often we buy and sell stocks, the more we generally lose. Warren Buffett chimed in on this reality when he said, “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
As human beings, our natural instincts are to take corrective actions when things aren’t going our way. However, this is often the exact wrong thing to do in investing.
Buffett has also said that “the stock market is designed to transfer money from the active to the patient.”
Worrying less about the market’s daily gyrations and staying patient are important keys but go against our human emotions. Famous value investor Seth Klarman said it best:
“In a world in which most investors appear interested in figuring out how to make money every second and chase the idea du jour, there’s also something validating about the message that it’s okay to do nothing and wait for opportunities to present themselves or to pay off. That’s lonely and contrary a lot of the time, but reminding yourself that that’s what it takes is quite helpful.”
All of the data and investor quotes presented get at the same underlying message. When purchasing a high quality stock, your ideal holding period should be forever:
“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” – Phil Fisher
“If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.” – Warren Buffett
However, we live in a dynamic world and are constantly prone to making investment mistakes. Instead of reacting to near-term changes in price of caving in to emotional desires, we follow five guidelines when we are thinking about selling a stock.
Our Five Rules for Deciding When to Sell Stocks
Four of our rules for selling a stock are applicable for all stock investors, and the fifth rule is primarily relevant for dividend investing.
Sell Rule #1: The Company’s Long-term Earnings Power is Impaired Stock prices follow earnings over long time periods. According to a study conducted by Turner Investments, which analyzed stock returns from March 1990 to November 2010, stocks with the strongest trend in earnings growth returned 11.5% per year, while stocks with the weakest earnings growth returned just 1.5% per year. Over this period, the S&P 500 Index gained 6.3% per year.
Warren Buffett makes a similar observation:
“Our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.”
Put another way, companies that are able to grow in value over time will ultimately see their stock prices move up with earnings. The number one reason why we sell a stock is if we believe the company’s long-term earnings power has become permanently impaired.
These are some of the hardest judgment calls to make, and they can make or break an investment’s return. If it was easy, we would be able to quickly identify and sell value traps while doubling down on high quality stocks that have been unfairly beaten down.
The best we can do is to try to understand the factors that are hurting the company today. Ask yourself if the reasons for the stock being weak are more likely to be transitory or permanent in nature.
Issues such as currency headwinds or sluggish growth in the economy are likely to resolve themselves over the next year or two and could be buying opportunities, whereas changing consumer preferences or new competition from China could permanently impair a company’s long-term profitability and growth potential.
Trying to place the factors hurting the company into one of these two buckets (transitory or permanent weakness) can refocus you on the fundamentals and help you better decide if you should sell your shares or potentially add to your position.
Sell Rule #2: The Stock’s Valuation has Reached Excessive Levels
If a company’s fundamentals are humming along as we hoped, we prefer to never sell and very rarely will. However, the price of a stock can deviate significantly from its intrinsic value for numerous reasons, many of which tie back to our emotional biases and herd mentality, and create rolling booms and busts.
The S&P 500’s long-term price-to-earnings (P/E) multiple is about 15, and the market has a way of reverting to the mean over time. We typically prefer to pay no more than 20 times earnings for our holdings, and we will start to look at them with a much more critical eye if their price-to-earnings (P/E) multiple exceeds 30.
This is just a general rule of thumb to help us remain aware of valuation risk. At any given time, we are due to own some companies that turn out to have been undervalued and others that were overvalued. By maintaining a well-diversified portfolio, company-specific valuation risk tends to cancel out and is the least common reason why we would ever sell a stock.
Sell Rule #3: The Position Reaches an Uncomfortable Size Some would call this a good problem to have. We bought shares of Boeing in one of our portfolios back in 2015. Our investment more than doubled, swelling to over 8% of our portfolio's total value.
While Boeing's long-term outlook looked great, the position size was becoming uncomfortably large. We prefer not to invest more than 5% of our portfolios in any single company, and even then the investment must appear to be a very high quality business with a fairly rather narrow range of potential outcomes.
To take some risk off the table and maintain a more comfortable level of diversification, we trimmed our stake in Boeing by about a third. Depending on an investor's risk tolerance and how many positions are held, this rule may not be an issue to consider.
Sell Rule #4: We Have a Better Investment Idea
Even the "best" investors get close to half of their stock picks wrong. The world is a dynamic place, and the market tends to be quite efficient. Fortunately, gains from winners are large enough to more than offset the underperformance of losers.
The point is, most portfolios almost always have at least a few stocks that are lukewarm holdings at best. While patience rules the day, it can be worth looking out for unique opportunities to upgrade into a higher conviction idea.
Perhaps a stock with a safer dividend, superior business quality, higher yield, or better long-term outlook becomes available at an attractive price. In those situations, which are infrequent, we will consider making a swap with one of low-conviction holdings.
Sell Rule #5: The Safety of the Dividend Payment is at Risk As conservative dividend growth investors, we understand that a growing dividend is often the sign of a financially healthy and profitable business. Dividends also fund our retirements and passive income needs, so the last thing we ever want to experience is a cut to our dividend checks.
Many investors will immediately sell a stock after it decides to cut its dividend, but we do our best to get out before the reduction is made. We gauge the risk of a dividend cut by analyzing a company’s most important financial metrics (payout ratios, debt levels, recent earnings growth, etc.).
To keep all of this information straight for thousands of stocks, we created a Dividend Safety Score system to assess how likely a company is to cut its dividend in the future.
You can learn more about our Dividend Safety Scores and view their realtime track record here. We prefer to avoid companies with low Dividend Safety Scores and will exit any holdings with risky scores in favor of more secure dividends elsewhere.
Final Thoughts: Selling Stocks Isn’t Easy
Knowing when to sell a stock is one of the biggest challenges investors face. Our emotions often handicap our ability to think rationally, and we find ourselves pursuing short-term income and profit gains far too often – even when we call ourselves long-term investors.
Combatting these dangerous tendencies is no easy task, but following a simple plan that (1) puts us in an emotionally stable place where we can think rationally and avoid unnecessary trading activity; (2) takes a critical look at the drivers impacting a stock’s underperformance, classifying them as either temporary or permanent concerns; and (3) really commits us to a long-term investment horizon can significantly help our cause.
