Recently, I wrote an article in which I provide strategies for buying a stock. In it I stress that investors can significantly augment their gains if they take advantage of market volatility and irrationality. While I discuss selling in that article, I do so for a very specific condition — I say that if you buy a stock and it reaches your target price, then you should sell it.
In this article I will talk a little bit more about selling a stock. Selling a stock is difficult psychologically because we look at a stock’s movements since we bought it as a reflection of our ability to trade and to select fundamentally undervalued securities. If a stock we buy is down, then we don’t want to face the possibility that we were wrong, and so we find it very difficult to sell. If, on the other hand, the stock is higher, this is positive feedback from the market, and the fact that we were right vindicates us so we feel that selling is a mistake. In short, because we have a gain or a loss associated with a position, we have an existentially driven bias that distracts us from the fundamental value of the stock in question.
If a stock you own has fallen in value, you have to accept one of two things: either your fundamental analysis was wrong, or your timing was wrong. In the latter case, you need to cut your losses and move on to something else. Of course, this is easier said than done. The reason for this is that it often isn’t immediately apparent that your fundamental analysis is wrong unless you are a short-term trader betting on a particular catalyst with a straightforward either/or outcome, such as an earnings report or the results of an FDA study. But if you took a long-term position, it might not be so apparent that your analysis was incorrect.