Choosing when to sell a stock can be adifficult task. For most traders, it is hard to separate their emotions from their trades, and the two human emotions that influence traders when they are considering selling a stock are greed and fear. Traders are afraid of losing or not maximizing profit potential. However, the ability to manage these emotions is the key to becoming a successful trader.
For example, many investors don't sell when a stock has risen 10% to 20% because they don't want to miss out on more returns if the stock shoots to the moon. This is the result of greed and a desire that the stock they picked will become an even big winner. On the flip side, if the stock price fell by 10% to 20%, a good majority of investors still won't sell because of their reluctance to realize a loss in the event that the stock rebounds significantly. There is the additional fear that they might end up regretting their actions if the stock rebounds.
So, when should you sell your stock? This is a fundamental question that investors struggle with. Fortunately, there are some commonly used methods that can help investors make the process as methodical as possible, and remove any emotion from the decision. These methods are the valuation-level sell, the opportunity-cost sell, the deteriorating-fundamentals sell, the down-from-cost and up-from-cost sell, and the target-price sell.
Key Takeaways
- Managing fear and greed is key to becoming a successful investor.
- Investors should be as methodical as possible, removing any emotion from their decisions.
- In the valuation-level sell strategy, an investor sells once a stock hits a certain valuation target or range.
- The down-from-cost sell strategy is a rule-based method that triggers a sell based on the amount (i.e. percent) that an investor is willing to lose.
Valuation-Level Sell
- The first selling category is called the valuation-level sell method. In the valuation-level sell strategy, the investor will sell a stock once it hits a certain valuation target or range. Numerous valuation metrics can be used as the basis, but some common onesare the price-to-earnings (P/E) ratio, price-to-book (P/B),and price-to-sales (P/S). This approach is popular among value investors who buy stocks that are undervalued. These same valuation metrics can be used as signals to sell when stock becomes overvalued.
As an illustration of this method, suppose an investor holds stock in Walmart (WMT) that they bought when the P/E ratio was around 13 times the earnings. The trader looks at the historical valuation of Walmart stock and observes that the five-year average P/E is 15.8. From this, the trader could decide upon a valuation sell target of 15.8times earnings as a fixed sell signal.
Opportunity-Cost Sell
An additional strategy is called the opportunity-cost sell method. In this method, the investor owns a portfolio of stocks and sells a stock when a better opportunity presents itself. This requiresconstant monitoring, research, and analysis of both their portfolio and potential new stock additions. Once a better potential investment has been identified, the investor then reduces or eliminates a position in a current holding that isn't expected to do as well as the new stock on a risk-adjusted return basis.
Deteriorating-Fundamentals Sell
The deteriorating-fundamental sell method will trigger a stock sale if certain fundamentals in the company's financial statements fall below a certain level. This selling strategy issimilar to the opportunity-cost sell in the sense that a stock sold using the previous strategy has likely deteriorated in some way. When basing a sell decision on deteriorating fundamentals, many traders will focus mainly on the balance sheet statement, with an extra emphasis on liquidity and coverage ratios.
For example, suppose an investor owns the stock of a utility company that pays a relatively high, consistent dividend. The investor is holding the stock mainly because of its relative safety and dividend yield. Furthermore, when the investor bought the stock, its debt-to-equity ratio (D/E) was around 1.0, and its current ratio was around 1.4.
In this situation, a trading rule could be established so that the investor would sell the stock if the D/E ratio rose over 1.50, or if the current ratio ever fell below 1.0. If the company's fundamentals deteriorated to those levels–thus threatening the dividend and the safety–this strategy would signal the investor to sell the stock.
Down-From-Cost and Up-From-Cost Sell
The down-from-cost sell strategy is another rule-based method that triggers a sell based on the amount (i.e. percent) that an investor is willing to lose. For example, when an investor purchases a stock, they may decide that if the stock falls 10% from where they bought it, they will sell it.
Similar to the down-from-cost strategy, the up-from-cost strategy will trigger a stock sale if the stock rises a certain percentage. Both the down-from-cost and up-from-cost methods are strategies that will protect the investor's principal by either limiting their loss (stop-loss) or locking in a specific amount of profit (take-profit). The key to this approach is selecting an appropriate percentage that triggers the sell-by taking into account the stock's historical volatility and the amount that an investor is willing to lose.
Target-Price Sell
The target-price sell method uses a specific stock value to trigger a sell. This is one of the most widely used ways by which investors sell a stock, as evidenced by the popularity of the stop-loss orders with both traders and investors. Common target prices used by investors are typically based on valuation model outputs such as the discounted cash flow model. Many traders will base target-price sells on arbitrary round numbers or support and resistance levels, but these are less sound than other fundamental-based methods.
Bottom Line
Learning to accept a loss on your investment is one of the hardest things to do as an investor. Oftentimes, what makes investors successful is not just their ability to choose winning stocks, but also their ability to sell stocks at the right time. These common methods can help investors decide when to sell a stock.
