Wednesday, March 26, 2008

When to Sell a Stock

People have a lot of tendencies that serve them well in many aspects of their lives, but can be harmful when it comes to investing in stocks. One of these tendencies is to prefer the familiar over the unfamiliar.

I saw this during the high-tech bubble when ordinary people with minimal investing experience suddenly had stock options worth more than their houses. For some reason, these people found it difficult to cash out even though the stock options represented 80% or more of their net worth.

I used to try a little mental exercise with these people. I would say “imagine that your options have been cashed out and the money is sitting in your bank account. Would you use it all to buy stock in a high-tech company at soaring prices?”

The usual answer was something like “No way! That would be a ridiculously risky thing to do.” But, to my knowledge, only one person who tried this mental exercise with me was persuaded to cash out most of his options. Most people continued to hold their options until well after the bubble burst.

For some reason, people felt more comfortable with the familiar situation where they continued to hold their options. Cashing out felt risky to them, even though cashing out actually would have dramatically lowered their financial risk.

A Simple Rule

Whenever you are trying to decide whether to sell some asset, you should ask yourself “if I had the money, would I buy this asset right now?” If the answer is no, then you should probably sell. This approach is particularly important when one asset has grown to dominate your portfolio.

Some Caveats

Of course, there are some caveats with this method of deciding when to sell. If you decide that a stock is worth owning at $30, and you buy it today for $29.99 per share, it makes no sense to sell it tomorrow for $30.01 per share.

You need to take into account trading commissions, the cost of spreads, and taxes. Based on these considerations, you may decide that a stock is worth buying below $30, should be sold above $60, and just held for any price in between.

This doesn’t necessarily mean that you should automatically sell the stock if it hits $60 say 2 years from now. If the company’s fortunes have improved dramatically, you may change your holding range to $50-$100. Even if the stock stays at $30, you may sell if the company’s business goes downhill, and your range changes to $10-$20.

Where do these ranges come from?

These ranges come from a fundamental analysis of the company’s business and future prospects. If you don’t know how to do this, then you should consider sticking to an indexing strategy for the stock portion of your portfolio rather than buying individual stocks.

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