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When Should You Sell a Stock?
Determining when to sell a stock is one of the most difficult decisions to make, not only from a financial standpoint but from an emotional standpoint as well.
Greed, hope, denial, delusion and faith are some of the emotions you need to deal with when you sell a stock. Because of these feelings, it’s much easier to buy than to sell stocks.
One way to overcome these emotions is to rely on simple math with what is called a “stop” or “stop loss.” This is the price at which you will sell a stock, regardless of what might be happening to the company or the stock market. A “trailing stop loss” is a particular type of stop loss (arguably the best type) that adjusts higher as the share price of a stock rises. This allows you to lock in profits.
It’s a great way to follow an important rule of investing: Limit your losses and preserve your profits. In other words, “cut your losers and let your winners ride.”
Let’s say you buy shares in Acme Bonegraft Company (ABC) for $50. The stock price steadily climbs to $100. That’s great, so now you need to protect your profit.
Setting up a trailing stop means that you pick a percentage, say 25 percent. If the stock price goes down by 25 percent below the highest closing price, you will sell the stock without any hesitation or hard feelings.
Remember, ABC is now worth $100 a share. So your trailing stop is $75, or 25 percent below $100. If the stock falls to $75, you sell it.
But business is good and ABC keeps climbing. It is now worth $200 a share. Your trailing stop is still 25 percent below the highest closing price, which is now $150. If the stock reaches $150 a share, you sell.
Sure, losing $50 per share is not fun. But because you can’t predict whether the price of ABC is going to rise to $300 or plummet to $30, you need to protect your profit. As they say on Wall Street, “nobody ever went broke taking a profit.”
Having a consistent strategy, in the form of a trailing stop, takes the guesswork out of when to sell. There is no thinking involved, no emotions, no falling in love with a particular company. When you hit your trailing stop, you sell. End of the story.
One more suggestion: instead of watching your stocks like a hawk throughout the day, watch them in the evening, after the market closes. Ideally, trailing stops should apply to closing prices, not intraday prices.
What’s so magical about the 25 percent number? Nothing. (Well, there is something, as discussed here). If a stock is very volatile, you could choose a higher trailing stop, say 33 percent. Or, if a particular stock keeps climbing and you are anxious about the market conditions, or you don’t want to risk losing 25 percent of your profits, you could set it at 20 percent, or even 10 percent.
Bottom line: 25 percent is a good compromise: It’s easy to remember, it allows some volatility, and it will always prevent a catastrophic loss.
Of course, there are many other reasons to sell a stock, but they tend to involve emotions or technical data:
- You should sell when you realize that you made a mistake (that’s a big emotion to overcome).
- You should sell when the price-to-earnings (P/E) ratio is insanely high (this is debatable, as a high P/E ratio may not prevent the stock price from climbing higher).
- You should sell when the stock reaches your price target (this is tricky at best).
- You should sell when your investment priorities have shifted (e.g., your risk tolerance decreased).
- You should sell when the company’s fundamentals go south (e.g., profit margin, earnings, cash flow).
- You should sell when a better opportunity comes up (this can be very subjective).
Investing is both an art and a science. Use trailing stops to take the emotion out of your investments, and your finances will be much better off.
Dr. Phil Zeltzman is a board-certified veterinary surgeon and serial entrepreneur. His traveling surgery practice takes him all over Eastern Pennsylvania and Western New Jersey. You can visit his websites at www.DrPhilZeltzman.com and www.VeterinariansInParadise.com.