When Do We Sell? Answer: When You're Losing 'Too Much' Money

by: Bob Wilson

There are six classic reasons to sell a stock:

1. You need the money to finance something or to loan money to someone.

2. In a taxable account you need to better balance gains vs. losses before the end of the year for tax reasons.

3. You have come across what you think is an attractive new stock idea and you judge it to be a better pick than one you hold.

4. You don't like some new direction one of your companies is taking or some change it's making or you just learned something and you don't like it.

5. You decide the market is seriously overextended, including some of your long positions.

6. Your sell discipline starts flashing red.

Let's look a couple of typical scenarios.

A. Your XYZ stock starts to rocket upward. During this ascent you have the impression that this previously unimaginably high price is based on some product or service that hasn't actually happened yet. The market's perception is that this will be the next big thing for XYZ.

These jet-assisted take-offs aren't usually sustainable. They tend to happen to small caps. If you see the hockey-stick or parabolic pattern on the chart, consider taking your windfall profit or some of it. Especially if XYZ suddenly drops about 10% in price in one day or one hour. The odds are pretty good that once the buzz dies down, if there was any, there won't be many buyers left. If you're right and XYZ starts to retrace its ascent on the downside, you could wait for this drop-off to subside and perhaps buy back some shares later on.

B. You notice that DEF is investing not only most of its cash but also issuing a hefty chunk of new debt in order to fund an acquisition that isn't part of the company's traditional business lines. This means some negative cash flow on the debt service, but more importantly it means that DEF is hoping to buy some expertise it wants. Peter Lynch used to call this "deworsification".

Lots of times companies use new debt wisely, so you have to know what they plan to do with the debt capital. If you don't like it, consider taking some of your money in DEF off the table. The basic consideration here is the effect of a corporate decision on earnings. If you are "wait and see", fine, but keep track of the news and how the market interprets it. There is one pretty good sign that you should consider lightening up: DEF's stock price starts dropping more than its normal volatility would show.

There has been on CNBC and Bloomberg recently an occasional snippet where somebody is asked why they are bearish, why they think the market is heading for a drop. I'm personally skeptical of these comments, as a rule. Here's what the huge top in the tech market sounded and looked like in 1999:

"Money" magazine had a cover asking, "How to Win in the Net Century". Inside was an article, "The Sensible Internet Portfolio", where six stocks were categorized as 'Stocks To Buy Now'. These six were Safeguard Scientifics (NYSE:SFE), Exodus, Inktomi, Earth Web (EWBX became DICE, as in "a roll of the" it turned out) and Ariba (NASDAQ:ARBA). Between October 22, 1999 and June 30, 2002 the best performer was Verisign (NASDAQ:VRSN), only down 87% (Exodus exited for good).

"Smart Money" had a cover, "The 10 Stocks for the Next Decade", featuring America Online (NYSE:AOL), Broadcom (BRCM), Citigroup (NYSE:C), Inktomi, MCI Worldcom, Monsanto (NYSE:MON), Nokia (NYSE:NOK), Nortel Networks (OTCPK:ARTM), Red Hat (NYSE:RHT) and Scientific Atlanta. By the market's bottom, the best performer was Citi at +7%. The average loss on the other nine was -67.8% (Monsanto was only down -5%).

The March, 2000 edition, which in hindsight was the market top, had a cover article, "15 GREAT tech stocks". Through June, 2002 the best performer was Hyperion Solutions, down only -46%. The group's average loss (June, 2002) was -78%.

"Business Week" had a cover article in December, 1999, "Where To Invest", with the leader, "Smart Investing for the Internet Age". Through June 30, 2002, the six featured stocks had an average loss of -58%, although one, Federal Express, was up +34%. MCI Worldcom became known infamously as "Worldbomb" because it basically blew up: CEO Bernie Ebbers was later convicted of fraud and conspiracy in connection with false financial reporting. Investors lost $180 billion on this stock.

Those magazines and similar publications have millions of subscribers and have been around for a long time. They have published a great many articles of benefit to investors. Even in the particular editions I referenced, there were articles talking about excessive valuations and the importance of diversification and of keeping the total percentage of tech stocks in a portfolio to a relatively modest figure.

I cite the articles above only to demonstrate that respected national magazines are not generally in the business of calling market tops. When they are lined up behind one dominant bullish investment theme, look out. This could easily be a strong sign of herd mentality, i.e. the conviction of the many: "Every good investment starts with the perception of the few and ends with the conviction of the many."

What about the situation we are all faced with quite a lot? We think our core positions should be almost never sold, but we also have a few stocks we're less confident about or maybe even a couple of flyers. When do we finger the sell trigger or go ahead and pull it? When do we compromise on buy-and-hold?

Buy-and-hold is fine as long as you're holding stocks that justify your faith in their fundamentals. But what if one of your favorites starts dropping? At first you aren't concerned because you know corrections are normal and can set up a new bullish cycle. Here's the question we all have to confront sometimes:

How low are we prepared to watch one of our stocks drop?

Most people would probably feel their answer to this question depends on the stock. This is because different stocks have different price volatilities. We don't usually sell just because a stock happens to drop out of its volatility downside range. But if not then, when?

My personal preference, the system I use most often, is to look at the chart first to see if the stock has been moving in a pattern that has a price support level. If my stock has broken this support it means that the bets are temporarily off while the stock finds its new level of price support, i.e. buyers return.

SA doesn't publish articles on technical analysis, so I can't get into this in detail, but the idea isn't hard to visualize: even if your stock doesn't have much of a pattern, you can still get a sense of whether it's "looking" for "someplace to rest" at a lower price. This will be its new support level, a price range where buyers will think the price looks good enough, so they step in and establish a new support range or level. We are probably not going to assume we can guess our stock's new support level. Then the question remains, how far will we tolerate a growing loss?

Am I talking about core, blue chip holdings here? Yes, I am. Never marry a stock. Holding hands is ok, but that's it. Just because a company seems to be a pillar of the market doesn't necessarily mean you can buy it and "forget it". In 1999 IBM went from $140/shr to $90 and in 2002 it went from $125 to $55. Most investors then, as now, felt that IBM should be held through thick and thin. But, folks, that's a lot of thin.

How do you know if a problem with a company is serious? You probably won't have a good feel for this. If you do, great. But if your stock continues to drop in price, trying to understand the reason for this is chasing after one of life's booby prizes. What good does it do if you figure out what's happening but rationalize holding the stock, only to see it decline heavily (like IBM did, twice)?

What I'm saying is we should all have a sell discipline of some kind that is simple to follow. The two approaches I favor are:

A) Use the chart. If your stock is breaking below support or below what you'd expect from its volatility, start lightening up.

B) When a stock has dropped by a percentage you choose, start selling. This drop might be down 20% from its recent high, so it's eroding your profit, or it might be down 20% below your cost. Is it any easier losing profit? Well, maybe.

Don't make the mistake of telling yourself you have a "paper loss", as though it isn't real. That "loss on paper" is telling you that you already have a loss. If you don't think you do, try selling the stock and see if the loss suddenly seems more real. My point here is not to demean anyone. My point is that you mustn't rationalize losses.

Losses are part of investing. They are going to happen. If your sell discipline starts blinking red, start lightening up. If you see your portfolio as a garden, a sell discipline helps you avoid those crisp, brown things. Stocks, unlike flowers, can come back, so long as it happens in your lifetime. But owning losers you think will recover some day might be an opportunity cost in addition to the mental anguish of wishing you'd sold. Remember Judy Collins' advice she recently mentioned on TV: it's ok to look back so long as you don't stare.

A sell discipline has only one purpose and that's to keep a loss you can manage from turning into a much larger loss that might compromise the performance of your entire portfolio. Or your retirement. Have you heard an investor say, "If it just hadn't been for XYZ, I'd have made...."? or how's this one: "How could I have been so friggin stupid?" Having a sell discipline excuses you from having to say those things.

Sometimes after your sell discipline says sell and you do, well, don't you know it, the darn stock starts back up. That's going to happen. It's the cost of your sell discipline's "disaster insurance". So should you only use a sell discipline for those flyers or non-core positions? That's a tough question and I don't have an answer. My attitude about it is this: if you've done your due diligence, your own research and you know you're buying a blue chip or at least a large- to mid-cap stock with seemingly sustainable strong fundamentals, then you might give it some slack past your usual sell discipline limit. But not much.

Here's one last anecdote. A wealthy gentleman, call him Joe (not his real name), and I used to sit on an investment committee for an institutional account. We were both members of the board. Once a year we met with an outside oversight committee appointed by the board: a banker, a CPA and an MD. One year the banker asked Joe what his sell discipline was. Joe explained that he didn't really have one, stocks rarely go Chapter 11, so patience is a better thing to have than sell discipline.

That's the other side of this coin, folks. Take your pick: sell discipline vs. patience. Sell discipline, what I favor, makes patience a lot easier. I think it can help performance, too, but the main thing is to avoid harm to our retirement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. I don't recommend a sell discipline with any security or market in mind. This article is about general advice which might or might not apply to a reader's personal investment situation.