When should you sell a dividend stock? You may have asked yourself this question recently as stocks continue to march higher and higher.
If you asked 100 investors this question, you would probably get 100 different answers. Some may even say "I don't know" or "never." Unfortunately, when building a dividend portfolio, most investors focus primarily on when to buy a stock (or the yield). Obviously, picking the right stocks and entry points are important, but a proper exit strategy is really the driver of long-term investment success.
This article highlights some of our exit strategy rules. That said, we would like to preface the article with this statement: In our opinion, "Buy and Hold" is not a viable long-term investment strategy. We can agree to disagree if you think differently (and you probably won't want to read the rest of the article).
Exiting a bad position or raising cash (i.e., selling winners) at the appropriate time are risk management strategies that you can't afford to ignore.
As discussed in previous articles, it's important to diversify your portfolio among various stocks and sectors, paying close attention to any concentration limits that have been set. These concentration limits are the first line of defense when you are monitoring your portfolio on an ongoing basis. For example, if a stock reaches your concentration limit for an individual stock, you will want to take some chips off the table to get back within your limit. Also, if your sector concentration limits are beached, you should lighten up your positions in that particular sector.
With that as a backdrop, below are details of some our exit strategy rules.
Establish Maximum Loss Thresholds
We all make bad investment decisions from time-to-time, it's part of the game. Knowing that, you should never let a few losses destroy your entire portfolio. Establishing a maximum loss threshold for individual stock positions is a great way to mitigate this risk. Depending on the size of your portfolio, we believe that the 0.50%-1.00% of total portfolio value is a good maximum loss threshold range to target.
For example, if you have a $100,000 dividend portfolio with a 1.00% maximum loss threshold, you should limit your loss on any one position to $1,000 ($100,000 x 1.0%). So if you bought 100 shares of McDonald's (MCD) at $100.00, you should limit your loss to $10 per share ($1,000 / 100 shares). In other words, your initial stop loss should be around $90.00 per share. This rule should also keep you disciplined with your position sizing because you don't want your stop losses to be so tight that they are triggered by normal market conditions.
A few widely held dividend stocks come to mind as we discuss this rule: Apple Inc. (AAPL) and American Capital Agency (AGNC). While these stocks are more volatile than your average "stable" dividend stock (and they may not be part of your core holdings), they are perfect examples to highlight the importance of this exit rule. In the last 12 months, both of these stocks were down over 45% from peak to trough (see charts below).
While these are more recent examples, investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks. It's actually difficult to find a dividend stock that didn't experience a decline of at least 30% during the 2008 recession. Below are the 2008 maximum drawdowns for some widely held "defensive" dividend stocks:
- Coca-Cola (KO): -40.6%
- Johnson & Johnson (JNJ): -34.4%
- Southern Company (SO): -30.4%
- Verizon Communications (VZ): -42.5%
Establishing maximum loss thresholds will help protect your portfolio from major corrections in individual stocks.
Have the Discipline to Take A Loss When You Need Too
This rule goes in tandem with the rule above, but we can't stress this enough. Most investors have a severe case of loss aversion (i.e., they emotionally can't handle taking a loss), so they end up riding a loser lower and lower with the hope that the stock will one day turn in their favor.
That said, breaching the maximum loss threshold should not be your only trigger to sell. If you are following the right metrics, your dividend stocks will show warning signs months in advance of a real problem. The key is to stay disciplined and to get out of a stock when red flags appear...no questions asked (even if it means taking a loss). Trust us, it's a whole lot easier to replace income yield than it is to replace capital (especially in retirement).
Other potential sell triggers include:
- Dividend cuts
- Revenue or earnings declines
- Regulatory or legal issues
Take Some Profits!
This rule is probably the most relevant right now given the market's recent uptrend. Generally speaking, we want to let our winners run. But there are times when a stock rallies significantly over a short period of time and it's prudent to take some chips off the table immediately. A good rule of thumb that we use for taking short term gains is to consider selling a stock that has increased over 5 times its dividend yield in a 6-month period. For example, if a stock has a dividend yield of 4.0% and it rallies over 20% within a 6-month period, it's a good time to take some profits. The theory is that if you can lock in 5 years of dividend payments in a 6-month time frame, you should do it. You can then reallocate this capital into a dividend stock that is trading at a more reasonable valuation to replace the lost income.
To keep tabs on potential profit targets, we maintain a Profit Zone Watch List (see example below) that highlights some of our high-rated dividend stocks that have had a nice short-term run.
If you were savvy enough to pick up some of the stocks on this list near their 6 month lows, now might be a good time to consider taking some profits. Investors should try to keep a similar list of potential profit targets in their own dividend portfolio.
Your individual exit strategy may differ from ours as it will depend on your overall long-term investment plan, but the important thing to take away from this article is that a proper exit strategy is critical to long-term investing success. We highly recommend writing down your exit strategy rules and placing them right by your computer so that you can be reminded of them every day. It's a jungle out there...make sure that you are properly prepared for whatever the market throws your way.