Your Cheat Sheet to Selling Stock

Source: Thinkstock

Source: Thinkstock

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.

If, on the other hand, your timing was off, then this means that the market has given you a better opportunity to buy more, and you should take advantage of it. Buffett followers are familiar with the story of how Warren Buffett bought The Washington Post (WPO) before it plunged 50 percent. He was right on the fundamentals but wrong on the timing, and the stock proceeded to skyrocket 10-fold in the following years. Short selling would have been a huge mistake. You therefore need to check your analysis of the stock carefully before deciding to cut your losses.

Selling a stock that has risen could be even more difficult because you feel vindicated. However, you need to remember that as a stock rises the bullish case also dissipates. But at the same time, a stock’s value isn’t set in stone — it constantly changes. So in fact after your stock rises from, say, $50 to $60, it is possible that there is even more upside left even if you had a price target of $60. In this case, not only is it a mistake to sell, but it might make sense to buy more!

However, it is always crucial to perform due diligence before reacting to a rising stock price. Consider that in the mid 2000s — before the financial crisis — bank stocks and stocks of Fannie Mae and Freddie Mac were rising steadily. Bulls felt vindicated, and as earnings rose, I’m sure there were many that were convinced that the fundamentals were improving as well. With hindsight we now know that this couldn’t be further from the truth: earnings, dividends, and share prices were rising as fundamentals deteriorated.

Thus, while it doesn’t make sense from a fundamental standpoint, in order to protect yourself from being wrong, it makes sense to use a stop order as an emotion-free lever for selling your winners. This strategy works because as a stock’s fundamentals seemingly improve we become convinced that this will continue indefinitely, and it makes selling that much more difficult. By agreeing to sell the stock if it falls by a certain amount, we not only lock in gains, but we can potentially limit our losses in the event that our analysis is incorrect; again, as we have seen rising earnings does not necessarily imply improving fundamentals. While this strategy may go against your fundamental value investing approach, just keep in mind that if you are stopped out of your position you can always buy it back.

Ultimately, I think this last point is of crucial importance when it comes to selling psychology. Selling is so difficult because we are afraid of missing the upside no matter what our stock has done since we bought it. But if you operate under the assumption that you can always buy back your position it will be easier to let it go.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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