When To Sell A Stock – Investing 101

Knowing when to sell a stock or fund is every bit as important as deciding what to buy, and twice as difficult–probably the hardest decision an investor must make. The quandaries are manifold. Investors who sell losers too late lose twice: once on the holding and once on potential appreciation from redeploying capital earned by selling the loser. Yet investors who sell losers too soon kiss away potential turnarounds–and significant profits.

Following statistical market trends is about as helpful for the average investor as using a divining rod. But it is possible to detect certain sell signals. Start by considering why you bought the asset in the first place. Ralph Wanger, director of Wanger Asset Management, which runs the Acorn Family of Funds, suggests that investors write down a reason when they buy a stock. Maybe “the company has an exciting new product, or your brother-in-law told you to,” he says. Periodically reevaluate the stock to see if the reason is still valid. If it is, don’t sell. But if you invested on your brother-in-law’s advice and he tells you he’s out of the investment, “it’s a very good time to consider selling,” says Wanger.

Investors who’ve chosen an asset allocation should revisit it once a year because some asset classes will grow or shrink, throwing off the original diversification plan. If an investment in technology ballooned from 20% to 40% of the portfolio, a moderately conservative investor suddenly may be facing too much risk. Investors’ goals can change desired asset allocations as well. Long-term investors tend to hold aggressive-growth securities. But suppose time has flown and retirement is only a few years away; those investors may want to sell some risky investments in favor of income-producing holdings.

Mutual funds are a little trickier when it comes to asset allocation because managers might shift their investing strategies. Successful small-cap funds often attract floods of assets. Even 100 companies with up to $1 billion in market cap can’t possibly absorb $400 billion of assets looking to be invested. This can force small-cap managers to buy the stock of larger companies in order to stay fully invested. Small-cap funds also tend to creep up in market cap, as their holdings naturally grow larger. Investors who want a fixed exposure to small-caps should switch to a manager who corrects for this by selling companies when they reach a target size.

The popularity of an investment may also raise a sell signal. “When you see a record amount of money going into a sector and its performance isn’t commensurate, that’s a warning,” says Robert Farrell, a senior investment adviser at Merrill Lynch. “The largest amount of money goes into a sector at the highest prices.” In the first quarter of 2000, aggressive-growth funds–mainly technology–brought in more than $100 billion, while “low-priced growth-and-income funds had a record net liquidation,” says Farrell. Soon, aggressive stocks plummeted, and growth-and-income funds made impressive gains. Farrell’s conclusion: “A wise investor would rather be playing where no one else wants to play, and be cutting back on the most popular areas.”

Investors often hope that this year’s dog will be next year’s hot investment, figuring that a good company’s stock price has to come back eventually. But eventually can seem like an eternity. In 1972, the Dow Jones industrial average first broke 1,000, says Ricky Harrington, a technical analyst at Wachovia Securities in Charlotte, North Carolina, yet it didn’t move higher for another decade. “That’s a long time for someone to be in an investment that’s not making any progress,” he says. If a stock is taking a jagged path downward, try selling on a bounce, but don’t wait too long for a bounce that may never come.

Value and Relative Value

When, if ever, should investors sell winners? “Professional money managers sell stocks only when the reasons they bought them are no longer valid,” says Robert J. Glovsky, president of Mintz Levin Financial Advisors, in Boston. For example, a stock selected because it was undervalued is considered ripe for selling when it reaches “a reasonable valuation.” To determine what constitutes “a reasonable valuation,” start with the stock’s fundamentals, its price/earnings ratio, book value, and cash flow. A stock with a high p/e is considered expensive–but is it more expensive than its peers? After examining the company’s numbers, if you’re still the least bit bullish, it’s probably too early to sell.

Relative value is another clue to sell-worthiness. When a stock or fund drops during a decline in its industry or asset class, that tells you nothing about its actual value. More troubling is when a holding dives while the rest of its group soars or stays put. It requires a little research to know if the stock price is being unfairly punished by investor misperception or some temporary earnings glitch. If real corporate problems aren’t being addressed, take the sell signal seriously.

It’s easier to gauge relative performance with mutual funds. At Morningstar.com, the Chicago-based leading tracker of mutual funds, investors can see how funds in a category such as aggressive growth compare with one another. “If a fund manager isn’t performing well against his peer group, we’ll trade that fund for another one,” notes Bill Carter of Carter Financial Management, in Dallas.

New management may be another tip-off to sell. Fresh blood often precedes a turnaround in a sick company, but what does it portend for a successful business? That depends. New management could follow the status quo or even improve upon it. But if the new management is an unknown quantity that can’t articulate a clear and realistic corporate agenda, investors should worry. Even with the same manager, a change in company focus, a questionable acquisition or sale, or a subpar product could be valid sell signals. Fund managers can also make unexpected investing changes, such as stockpiling cash or switching from stocks to bonds. Whatever the merits of the manager’s decision, investors have to ask whether it suits their needs.

No sell decision is complete without considering its tax consequences. Capital gains taxes cut into the returns on a profitable stock, so the investment you intend to replace it with has to perform even better to recoup the tax bite. An alternative is to sell a losing position and use the capital losses to offset capital gains. Investors don’t even need to eliminate the losing position from their portfolio altogether. For example, if you like the losing stock for the long-term, you can sell it to harvest the loss and replace it with one from the same sector that has similar characteristics.

Investors can also reduce taxes by holding stocks for more than a year, until they’re eligible for the long-term capital gains rate of 20% versus the short-term rate of up to 40%. “For someone who’s close to the cutoff, it’s tempting to wait,” says David Kahn, a managing director at American Express Tax and Business Services. Of course, during that time, the stock’s price can drop. That means that sell decisions should never be driven purely by tax considerations, says Kahn.

In the real world, a sell decision may have nothing to do with taxes or valuations but with how to finance a child’s Ivy League education or a new Maserati. Which holdings do you liquidate first? Start with the losers, then look for companies with falling earnings or those in declining industries. Other possibilities are stocks that trail their sectors’ averages in sales growth, net profit margin, or return on equity. Also, if a stock’s projected rate of earnings growth is less than its p/e ratio, many analysts would consider it overvalued and ripe for cashing in while the price brings a bonus.

These scenarios represent a range of potentially sell-worthy situations. Remember that whether to sell or not is only the first question to ask and that the answer often lies in understanding the investment’s raison d’être.