Reasons to sell a stock

Ask why you bought it in the first place.

David West 0

(Photo: artpartner-images/Getty)

It’s been a quiet week in the markets (yes, they’ve been very choppy, but there hasn’t been any compelling news to cause it). This week, there is no one overriding issue that is preoccupying investors. Three weeks ago, Italy and only Italy was on everyone’s mind. More recently it was Greece and its version of the sovereign debt dilemma. And only a few days ago all the world’s eyes were focused on the U.S. debt ceiling.

All three crises were settled in time. So now is as good an occasion as any to get into one of the tried and true investment axioms, a tool that do-it-yourselfers and advisor-assisted investors can practice over and over again until it becomes second nature. Let’s start with this anecdote.

Once upon a time, a friend of mine saw a snazzy red sports car gleaming in the dealership showroom window. “I want that,” he said, in an unmistakable second-childhood tone.

“How are you going to pay for it?” I asked. This was in the days before dealer financing became widespread, and nothing down, no interest for the first year became the norm. My friend could afford the car, of that there was no question. He owned two restaurants, had a good income, and could easily borrow the money. In terms of financing the purchase, he had plenty of options.

His response to my question, however, floored me. “I could sell my bank stocks.”

My main, but unvoiced reaction to my friend’s answer, was “What’s the connection between you wanting a new car and the decision to sell your bank stocks?” Of course, there wasn’t any.

That situation sums up the main axiom for today, something they drill into you in the three years of the CFA program: Sell when a reason to sell appears. You don’t sell a stock because it went up, and you don’t sell it because it’s gone down. And you certainly don’t sell a stock because you saw a fancy red sports car in some showroom window.

This may sound on its face like a simple axiom, but it’s sufficiently hard to put into effective practice. Think of it this way. When you buy a stock in the first place, write down why you bought it. You expect its earnings to increase, or its multiple to expand, or its undervalued assets to be recognized for their true value, or you believe the company will be a takeover target. Whatever your reason for buying is, write it down.

That makes the sell decision really easy. Either everything you expected to happen did happen, and there’s no further reason to hold the stock, or it didn’t happen and it’s not going to.

Academic studies show that retail investors spend about nine times as much effort in formulating buy decisions than they do sell decisions. The same studies show that investors who spend more time than others on sell decisions get better returns. Maybe that’s true, and maybe it’s not. But it does make sense to write down why you bought a stock, because it certainly simplifies the sell decision.

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