When I first started investing in the stock market, buying a stock came naturally because it is no different from shopping. If I like something, I just buy it. However, when it comes to selling, it didn't feel natural and I found it hard to do. You see, when we shop, we buy things to consume. Most of the time, we just use the product until it either spoils or becomes obsolete. We will then discard the item or donate it if it can still be used. Even if we want to sell second hand, the consideration is to price to dispose.
When it comes to stocks, the consideration is different. We would like to be able to sell at the top so that we can lock in the greatest amount of profits. Hence, we are always wondering when is the best time to sell. Unfortunately, no one knows. Most of the time, we end up regretting our decision to sell because prices went higher than where we sold. There is another subtle psychological impact when we sell. It is the moment we realize whether our decision to buy the stock was the correct one. I've had my fair share of this feeling but over the years, I've come to realize that there are only a few reasons why we should sell a stock. And they all have nothing to do with whether the stock is sitting on profits or not.
1) The Premise For Buying Is No Longer True
If you have done your homework, you should have at least a good reason to buy a stock. But after you bought it, things can change. The reason you bought it may no longer be valid. If you would no longer buy the stock today, then it makes no sense for you to hold on to it. If we are sitting on profits, it should be easy to sell the stock. The problem is when the position is underwater. We are reluctant to sell because it means realizing a loss. There is always the hope that prices can rebound. While it is not impossible, my experience tells me that it is better to cut and move on.
In my case, I buy stocks hoping to ride an uptrend. Once the premise for the uptrend is no longer true, I exit regardless of whether the position is profitable or not. It helps that I do not look at individual positions but I consider the entire portfolio within the context of a proven back-tested strategy. I know that not all stocks will go into a good uptrend but I just need a few to deliver the profits for my portfolio. But for this to work, I must be diligent in cutting out the losers. It is similar to cutting out weeds for healthy crops to grow.
2) The Need To Rebalance The Portfolio
If you are holding several stocks within your portfolio, chances are only a handful of stocks will outperform the rest significantly. They will grow in size and take up a greater allocation in the portfolio. Eventually, your portfolio may be driven almost entirely by the performance of these stocks. If you wish to maintain a diversified portfolio, you would want to rebalance to reduce the size of the outperformers and redistribute capital to the other stocks. Rebalancing is a good way to systematically take profits from outperformers and redeploy them to laggards.
3) The Need To Withdraw Cash From The Portfolio
Sometimes you might require cash from your portfolio. This might require you to sell down positions to raise cash. A common practice is to sell down only profitable positions. However, by doing so, you are assuming that the losing stocks will do better than profitable stocks going forward. This may not be true. If you do not want to disturb the current allocation in the portfolio, a better approach is to sell a constant proportion across the entire portfolio. For example, if you wish to withdraw 5% from your portfolio, you should sell 5% of every position as far as possible. The consideration here is to minimize transaction costs and maintain portfolio allocation as far as possible. The best time to withdraw cash is to do it during regular rebalancing because there will be changes to the portfolio so you can rebalance to the new portfolio size after factoring in withdrawals. This can help minimize transaction costs and help shift to the new allocations post-rebalancing.
4) There Is An Alternative
We might find ourselves in a situation where we are holding on to a disproportionately large position in a stock in relation to our total wealth. It could be due to our accumulation of company shares over the years as part of our compensation package. It could be due to inheritance. Holding on to such a large position is not wrong by itself. However, it presents a concentration risk. It can cut both ways. If you wish to diversify your portfolio to reduce concentration risk and have found a suitable replacement, it may be a good idea to sell some of your stocks to buy into the alternative.
There are a number of reasons why you should sell a stock. But none of them should be based on emotions or the P&L of the position. As long as it fulfills the purpose behind the sale, you should not care how the stock performs after you sell it. After all, nobody has a crystal ball.
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