For an investor with a long term time horizon, deciding when to sell a position can be hard. As investors, we buy quality companies and hold them as owners. Year after year these companies' strong businesses and management create value and return it to shareholders. At what point, if at all, do you sell or trim a winning position? Here are five rules to help guide your decision. [Note: This article is for investors, not traders.]
Rule No. 1: Let Your Winners Run
Letting your winners run is a well-known principle. In general, stocks that go up (breaking out to new 52-week highs) tend to keep going up. Quality companies with momentum are hard to beat. As investors, we are not in a stock just to pick up a few points. We are looking for our positions to double or better over time. The only way to do that is to give them time and let them run. It's hard to fault someone for selling out after a nice 10% or 20% gain. But if you are in the market for the long haul and own solid companies, you are generally better off staying in a stock that has made nice gains to let it continue to run and go even higher over time. It may reverse course and drop a few points for a period, but that kind of action is normal and even healthy. Be patient and let time and the quality of the company work for you. [There are exceptions to this rule - Rules 2-4 below.]
Rule No. 2: Market at All Time Highs
At this writing, the market is currently at all-time highs. Along the way, this rising tide has lifted many boats and a number of long-held positions have run up. And they have moved up dramatically over a relatively short period of time. In the present environment, the percentages call for a position that has moved up sharply to be trimmed. For example, I have recently trimmed two of my long-held core positions: Verizon (NYSE:VZ) and Phillip Morris (NYSE:PM). I continue to like both of these companies but feel they have moved up too far too fast in the context of the overall market making new all-time highs. Their run up has also swelled their place on a percentage basis in my portfolio to a level where prudence indicates they should be trimmed. If the long awaited correction in this market comes, I will rebuild these positions on the dip. If it doesn't come, I will have missed some gains on what I trimmed but will still do well on the rest of my position.
Rule No. 3: Stock has Gone Straight Up
There are times when a stock is the absolute darling of the market and goes straight up. When that happens you can be guaranteed it will end at some point and the pain will be severe. The question, of course, is when will it end and what do you do if you are smart and lucky enough to be in on the ride up. A recent example of this is Apple (NASDAQ:AAPL). It was a big winner for a long time but when the tide turned recently, it was a very painful ride down. When a stock moves up as fast and as resolutely as Apple did, it is simply prudent to begin to reduce the position at intervals along the way up. In a stock that traded in the $300-$700 range like Apple, trimming at intervals in or around each $100 level of gain will harvest some profits and still keep you in the stock if it continues to rise.
Rule No. 4: The Position is Too Large as a Percentage of your Portfolio
Depending on the size of a given portfolio, a diversified investor may hold 10-30 or so individual stocks, various mutual funds and ETFs. With respect to individual stocks, a typical recommendation is to have no position occupy more than 5% of the total portfolio value. While I do not personally adhere to this recommendation (I prefer to underweight and overweight my positions in stocks and sectors depending on my research), there is a seat-of-the-pants comfort level I feel where the size of a position simply gets too large and needs to be trimmed. This is an individual risk tolerance decision and every investor must draw his or her own line. However, even if one has a high level of tolerance for risk, it is prudent to maintain a balance so no position gets so big your financial future rises or falls with one (or even a few) stocks. When a position gets too large for your comfort level, trim it back.
Rule No. 5: Accounting Problems
When a company announces it has to (or may have to) restate earnings, or that there are other accounting irregularities, the stock is in trouble. Aside from the immediate negative reaction, accounting problems often indicate long-term issues both in management - which is only now catching up to the problem, and in operations, which may be why the accounting was aggressive in the first place. Management credibility and the corporate culture at the company are at stake. Restoring them in the minds of investors will take several quarters of good performance and confidence building. There are usually better opportunities than waiting around for such long-term changes to happen, if they happen at all.
Investing is uncertain. Picking the right time to sell or trim positions is not easy. And it is unlikely you will sell at the top (without blind luck). But if you consistently manage your positions, harvesting gains following prudent and sensible rules, you stand the best chance of increasing your overall performance.