When to sell stocks is as important as what stocks to buy. With zero-commission trading becoming more widely available today, the opportunity cost of entering and exiting trades has never been lower.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.”
In this article, we touch on a few topics such as how we think about cashing out investments, when to sell a winning stock, how to protect stock profits in general. This applies similarly to managing losses. In addition, we summarize the 3 things investors should know on when and how to take profits.
In fact, one of the key differences we find between a good and great investor is how he/she manages its downside risks.
Discipline, discipline and discipline
The answers regarding when to sell stocks and how to protect stock profits become clearer if investors have the discipline and appreciation for risk management. Our article on “How to Make More Money with Risk Management” highlighted the risk management toolkit every serious investor should think about. This applies to all spectrum of investors, both long-term and short-term.
When and how to take profits
When and how to protect stock profits and limit losses is an intricate concept that even professional investors may lose the discipline at some point in their investing journey.
Regardless of one’s beliefs on how the stock market works, we acknowledge the following conclusions derived over our combined investing careers and experiences.
- “Markets can stay irrational longer than you can stay solvent.”
- “No one ever went broke taking profits.”
- “A repeatable investing process/framework is a key element in risk management.”
Regardless of whether you’re a long or short-term, investors must be clear on 3 things before entering any investments: target return, loss tolerance and time horizon.
Target return, defined in % terms, is what you expect to gain from an investment. This is the level where you start taking profits.
First, investors need to be define a realistic target that is at least based on some sort of technical or fundamental metrics. For example, if a stock is trading at 5.0x P/E ratio, and you expect it to trade at 6.0x P/E, then a realistic target could be +20%, all else being equal. While company fundamentals change over time, it is worth nothing that a constant moving target return defeats the purpose of having one in the first place.
Next, with the target return set, the answer to the question of “when to sell a stock” now seems pretty obvious. Consequently, there are no fool proof methods on how to take profits on stocks. The consensus among the contributors here is to take profits on a scaled-basis, similar to the enhanced dollar cost-averaging method we talked about.
For example, assume that you have target return range of 20-30%. The idea is to take profit periodically in the range. We like the idea of selling more as the stock moves higher in the range, Hence, taking profits on a scaled-basis.
Loss tolerance, or stop-loss limit, is the max % loss that one would take before closing the position. Broadly, it acts more like a guideline rather than strict rule.
Similar to target return, loss tolerance should be based on certain fundamental or technical measure(s) of investors’ choice. To add, this should be considered in conjunction with the volatility of the stock.
Volatility of a stock is simply the variation of returns over a time period. This useful because if a stock moves +/-10% frequently, there’s little meaning in having a loss tolerance of 5%, since it can be breached easily nullifying the goal of this exercise.
Another thing to consider is your own risk appetite. Do you feel comfortable owning a stock that can move aggressively? Of course, there are ways around this. Investors can manage portfolio volatility by varying the size of investment.
For simplicity, if we assume that stock returns are independent of each other. Then, the portfolio volatility contribution of investing 20% of your portfolio in a stock with a volatility of 5% is similar to investing 5% of your portfolio in a stock with a volatility of 20%, mathematically speaking. In other words, to take a more measured approach, investors can consider lowering the dollar amount of investments for highly volatile stocks.
Now, having set a loss tolerance, again, the answer to “when to sell stocks” is clear. Interestingly, there’s a twist. For losses, there are a few options.
The obvious one would be to close out the position. This can be done on a scaled-basis or closing the position directly. The other option is to add to your existing positions, or average down.
Thinking about your loss tolerance beforehand forces investors to have a plan when it happens. In a way, because we’re setting out our modus operandi in advance, chances are we’re more likely to make well-thought-out decisions. Often, this drastically reduces emotional investing.
Finally, your investment time horizon. A straightforward guideline for any investments, but one that’s often missed. For example, we adopt a 3-5 years investing time horizon in our portfolio.
Setting a time horizon can be tricky because of its subjectivity. Unless you’re focused on catalyst-driven investing, ie: results, corporate events etc, a longer-term time horizon would fit better for most investors, in general.
Having an investment time horizon helps builds an idea of your target return and loss tolerance level. In simple terms, it provides an exit mechanism for your investments regardless whether target return or loss target have been met.
Perhaps a little controversial, we focus not only on stop-loss, but also time-stop. Closing a position and hitting the reset button encourages clearer, non-bias and non-emotional driven investing. Investors can always revisit and reopen positions again if there are compelling reasons to do so.
Investing taught us lots of life lessons. From how to protect stock profits to intriguing concepts such as behavioural investing. In our view, having a framework and being discipline remains one of the key criteria of a successful investor.
You have no idea the countless times I check prices of stocks sold, hoping that they’re trading way below where I sold, just to feel a little smarter. And similarly for stocks I bought.
But, investing shouldn’t be this way. We can be more efficient and effective with our time. Hence, why we built this into our investment process. The goal is simple, as investors, you should focus on what you’re good at, which is finding investment opportunities that make money.
Here’s a quick re-cap of what we think investors should consider on how to take profits
- Target return: Setting a realistic range of return for an investment. Start taking profits once in range.
- Loss tolerance: Similar to target return, start closing positions once it hits your loss tolerance level.
- Time horizon: Represents time-stop, the point in time when you will close your position if it does not rise or decline as expected.
Finally, your daily P&L shouldn’t reflect your emotional state. Let the money work for you and not the other way round. Buying and selling based on price actions alone rarely lead to profitable outcomes.
Hopefully, from now on, the answer to the question of when to sell stocks, specifically, when to sell a winning stock is a trivial one.