Investors often have a harder time with the decision to sell a stock than they do with the decision to buy. This, of course, means that more mistakes happen on the selling end of things. This problem arises because emotion creeps into the decision process more when we already own something. There have been a series of university studies recently that show that we tend to value things more accurately when we do not own them. The same is true for stocks.
When an investor buys a new stock, she has done sufficient due diligence (we hope!). A value investor is usually hoping to own the company indefinitely, or at least until something fundamental changes. This is a solid approach to investing, but the phrase “until something fundamental changes” can be confusing: especially when emotion is complicating the decision process. Each of us will eventually push the sell button to exit an investment, but we often do it with less clarity than we had when we bought it.
Here are some tips for selling a stock with more clarity, rationality, and less emotion. You can do the first step the day you buy a stock. Write a paragraph describing why you are buying the company and what you expect going forward. This is the initial investment thesis and you can periodically refer to it in order to assure that thesis creep (emotion clouding your original thesis) doesn’t cause a selling mistake.
The second technique I recommend is ranking your holdings from first to last in order of your conviction about them. Though somewhat subjective, this may help you think about your individual confidence level in each holding independently. I know that sounds challenging, but once you get started it often moves along easily. It should help with your thinking, as you are forced to compare confidence levels across a range of different businesses. I recommend updating this list every three months. This list doesn’t have to be perfect, but it helps you shape an understanding of what you hold. It’s also a good starting point for deciding what to let go of when a compelling new opportunity comes along.
Now that these two aids are in place for reference, we can look at some reasons a value investor might be compelled to sell.
Fundamental changes to the business are the most important reason to exit an investment. It is also where that thesis paragraph you wrote when you bought the stock comes into play. The difficulty in assessing fundamental changes comes because usually the changes are incremental and an investor can easily dismiss them on a case-by-case basis until it is too late to exit profitably. The best way to deal with this issue is to review your company on a monthly basis (news, fundamentals, competition, etc.) and compare what you find to your initial investment thesis.
Valuation is another chief complication when trying to make the correct sell decision. While determining fair value and selling when the stock reaches that price may seem simple, it’s not. It is difficult to accurately determine fair value because an investor has to consider many variables and needs to make accurate assumptions. While it’s useful to have an idea of what an investment is worth under various scenarios, I generally sell only part of a position when the stock becomes overvalued. I don’t want any one stock to become too large a part of the portfolio and I don’t want to rely too heavily on a company with no margin of safety, but I find that stocks that have risen to fair value often continue to prosper past that point.
If an investment is undervalued and nothing fundamental has changed, an investor may still elect to sell to take advantage of a better opportunity elsewhere. While a value investor’s objective is to hold a stock forever, she must also keep in mind that her money might serve her better invested elsewhere. The issue here is not a shifting thesis, but rather a thesis that doesn’t work as originally anticipated. Here is where the rank ordering comes in. If a company is moving down the ranking list each time it is updated, it might make sense to look for a higher-conviction investment.
While it would be nice if each of our investment decisions turned out to be long-term winners, they probably won’t turn out that way. I expect about 6 out of 10 investments to work as anticipated, with the rest either performing mediocre or poor returns. This is all part of a comprehensive investment plan, and value investors don’t get down on themselves when an investment doesn’t work. Instead, they work through a rational review method, and if the situation warrants, they sell.