When to Sell

Eric: I have a pretty good sense of what to look for when purchasing a stock, but I don't really know when to take my gains or when to cut my losses. Basically, when is a good time to sell a stock?

A: We have to always remember that buying and selling are opposite sides of the same coin. You can use a value approach to sell as well as buy. The first scenario is that the shares you are holding have increased in value significantly. At this point you are wondering whether it is wise to sell and take a gain or hold on to the stock for future increases. Here is where value tends to conflict with intuition. You will probably feel the inclination to sell and justify it to yourself along the lines of the price being significantly higher than your estimate of the stock’s value. Watch out for that word feel; speculators buy and sell on feelings, investors buy and sell on reason. There are three good reasons to sell your shares. The first is that you have an immediate need for the money that cannot be satisfied in any other way. Think of natural disasters or a sudden increase in the cost of tuition. The second is that the qualities that attracted you to the company have changed for the worse. This could range from an obsolete product line, new management that does not hold shareholder-friendly ideas (issuing options that have no relation to operating performance) or to any kind of fundamental change in the company with which you do not feel financially comfortable. The third and best reason is that you have found another opportunity that more than justifies the costs and taxes associated with trading your current position for the new one. When you sell a stock, you incur three kinds of costs. The first is commission, or what the brokerage house will actually charge you to sell your stock. The second cost is taxes. There are two types of taxes that you have to worry about when selling your stock: short and long-term capital gains taxes. When you sell your stock at a profit, the government will charge you the short-term capital gains rate if you hold your stock for less than a year. If you hold it for longer than a year, you will be charged the long-term capital gains rate. The short-term rate is much higher than the long-term rate. The third cost is opportunity cost. Opportunity cost is what you give up in order to get what you want. You want to realize the gains that come from the stock sale; therefore you must give up any future profits and owner-benefits that come with holding the stock that you are selling. If the new opportunity presents enough benefits to cover these three costs, sell your current holding and buy the new one. If not, stay put. If you believe the business fundamentals have changed for the worse in a way that you cannot tolerate, then do not wait to sell even if the current price will bring you a loss. I guarantee you that waiting around will only bring you more financial heartache. The second scenario is that the price has dropped significantly but there has been no change in what brought you to buy stock in the company. Do not decide to sell a stock just because the price has gone down. Think of price decreases as opportunities to buy more of a good thing at a lower price. If you buy a share at 50$ with your estimate of value at 70$, it’s a good deal at 50$ and a steal at 30$. Investing is as much about your personality as it is about the tools you use. Patience and confidence will always win the day.