As a private investor I make as many as 750 trades in a year – selling as well as buying. I’m considered a day trader by my broker as I fit the criteria, but most of the time I do not close a position on the same day as I opened it. Like most traders, I place a very high emphasis on gaining a good entry point for any position, long or short, stocks or bonds. But one thing I could do better is gaining better exit points. Right to the heart of the issue, when should a stock be sold? To answer this question, we must first take a look some common investing strategies.
Buy and Hold: If you are a buy and hold investor, selling a position becomes even more crucial. Your position’s progress is measured over a longer period of time, and the gains in some cases can run up to 150% to 200% or more over several years. Selling too soon will shorten that gain and place you back into the risk factors that surround buying the next stock. Volatility and fluctuation should have less of a bearing on the decision to sell as other factors such as the strength of the economy and growth of the company could mean that good returns should continue. It takes quite a bit of courage to be a buy and hold investor, as you must sit and watch the stock go down when the markets drop, hoping that the losses will turn into gains when the markets rise. One way to mitigate this pressure is to avoid following your stocks too closely. Balance them semi-annually or annually. If you look at losses every day, it will grate on you enough to push you out when you should stay in.
When does a buy and hold investor sell? When the marketplace has changed against the paradigm of the company’s business you should sell. For example: Kodak cameras and film once ruled the marketplace until digital cameras came along. The time to get out was when the paradigm shift took place.
Income vs Growth: If you are primarily an income investor with a smaller emphasis on growth, your position’s horizons will last potentially as long as the buy and hold investor’s. The major difference comes in the method the yield is determined. Yield comes in the form of dividends and/or interest. Dividend yields will vary according to the price of the security as well as the amount of the dividend that is declared. For preferred stocks, this amount is in the contract, and must be paid before common share dividends are paid (including any arrearages). For fixed instruments such as bonds, notes, and CD’s, the rate is also a part of the contract, as well as the contract’s duration. The value of fixed instruments can also fluctuate owing to market forces, but what drives the fluctuation is usually different. The market rates of interest as well as the credit of the companies issuing the fixed instrument have a major bearing. A change in the market rate of interest will sooner or later force changes in the value of the fixed instruments you hold. Dividend returns are harder to predict as the company can change dividend amounts or postpone them. But the same general principles apply in that the amount of the dividend and the price of the stock form the yield.
When does an income investor sell? When interest rates rise, and other investors are going after higher coupons (the actual interest payment) is the answer. The value of fixed instruments held at the lower rates will begin to drop. One thing to remember here is that by holding fixed instrument to duration, the investor will not have any losses other than the premiums paid when the bonds were acquired. Dividend investors will also face the same dilemma, as rising interest rates could cause numbers of investors to sell, driving the value of the stock down. One tip here is to refer to the yield when the position was acquired. That yield will not change with the changes in price.
Short Term Traders: A short term trader seeks to maximize returns (growth and income) in as short a space of time as possible. For a day trader this could mean a matter of hours or even minutes. But most short term investors have longer horizons measured in days, weeks, or months. Many of the same principles and fundamentals apply to short term investors as they would for buy and hold investors. However, durations are shorter and the tolerance for losses is much tighter. As a short term investor myself, I pay much more attention to the duration of investments, seeking to pull the gains out and then liquidate. It’s true that I sometimes forgo upside potential in order to protect the downside, but the overall goal is to pick up gains and block out severe losses.
When do I sell? I can’t speak for all short term investors, but I follow short term trends and look for an exit when the trend changes. I typically use sell stops or buy stops to block long downslides and turn the money around as soon as I can into positions that are on the upswing.
Capital Preservation: Every investor regardless of strategy must have a fallout point where selling is required for capital preservation. This is usually thought of in terms of a percentage loss from the initial purchase. Additionally, the amount of this pullback tolerance generally varies with duration – the longer the duration of the security, the greater the pullback allowance. Buy and hold investors might have a tolerance ranging as high as 25%, whereas for day traders it might be only 1 – 2%. For the average investor starting with a 10% tolerance is usually a good rule. The best way to execute this rule is to initiate a sell stop at 10% of the initial purchase right after completing the purchase. That way the stock will sell itself, and you won’t agonize over what to do with it when it goes down. When the stock goes up, you can adjust the sell stop to a new higher point.
What do I do for capital preservation? For long positions I will initiate a sell stop of anywhere from $0.25 to $2.50 per share depending on the share price. The greater the share price the greater the amount of tolerance. I also determine the difference based upon the stock’s high water mark – ie. the highest point it closed at adjusted daily. This way I lock in any gains the stock made before it begins to pull back. For short sales I will set up 5% fallback the first day and adjust it regularly as the position improves.
Summary: Studies have confirmed that fund managers in particular do not spend the same amount of time in liquidating stock positions as they do in acquiring them. However, selling or liquidating a position should require the same time and effort that acquiring the position took. Each investor should focus on what is the best exit strategy for his/her overall investing plans and not simply drop a position like a hot potato when it pulls back a nominal amount. In the final analysis, capital preservation must come into play at some point.
Sources: Buttonwood: Sales Assistance, The Economist, April 27, 2019