Some stocks were meant to be held for a lifetime with systematic purchases. Other stocks are most profitable during certain phases - most notably momentum stocks. While following popular stock picking methods might give you a good entry price, you can still be left with a loser if you don't know when to sell.
What are some common methods for triggering a sell? Let's review a few:
Rebalancing Your Portfolio
This is one of the easiest methods to follow since your buy rules are also your sell rules. For instance, one of my dividend stock selection strategies look for:
- Yield above its 5 year average
- Yield greater than 3.5%
- 5 year annualized dividend and earnings growth greater than 10%
Every 3 months, an investor should examine individual companies in the portfolio to ensure that all of the above buying criteria are still true. If not, he may sell the stock and replace it with a company that meets all of the above rules.
On November 12th, 2011, the following companies made the buy list (figures are true as of November 2011):
American Greetings Corporation
Lockheed Martin Corporation
Strayer Education, Inc.
At the end of the three month rebalancing period in February 12th, 2012, these companies are reconsidered. Strayer Education and Raytheon have trailing yields that dipped below 3.5% and Lockheed Martin booked a 5 year earnings growth rate below 10%. These companies are liquidated and others are included.
Out of curiosity, how well has this strategy performed? Over the three month period this would have returned 14.26% vs the market of 7.26%. If we allocate capital for an optimum of five stocks to prevent loading up on one or two stocks, our annualized return drops to 9.29%. Annual portfolio turnover is 141.66%.
This rebalancing method is simple to follow. At your predetermined rebalancing date you simply run your stock screener and review your current holdings against it - with some due diligence of course. The cons of such as system are:
- It is highly arbitrary as to how often you rebalance. A company might turn into a sell one week into your rebalance period which has you holding a loser for months
- Why should the buy rules be identical to your sell rules? If we buy stocks with higher yields but it dips because of a steep price run-up on good news - does that necessarily make it a sell?
- Transactions costs and slippage also add up with frequent rebalancing.
Of course, you can modify your rebalancing strategy to lessen the impacts of these downfalls.
Separate Buy and Sell Rules
Who says that the inverse of your buying criteria should necessarily be your selling rules? Perhaps you have a list a mile long of what sort of companies you like to buy but very few rules when to sell.
As an example, we will use our buying criteria for dividend stocks. We will restrict our selling rules to a 5 year earnings or dividend growth rate falling below an annualized 10% (or whatever selling rules you think are pertinent). We buy when yields are relatively spiking and above 3.5% on an absolute basis, we do not consider these to be important aspects when selling. A quickly rising stock will lower yields but can still be a good holding when looking at total gain.
The results? From an annualized return of 9.29% we jump to a 5 year annualized return of 14.81% and portfolio turnover drops down to 39.5%. Once you factor in transaction costs of $20 per trade and 2% slippage the excess gain increases from an annualized return of 3.68% with 3 month regular rebalancing to 14.74% with the separate buy and sell rules. The bonus with this method is that you can greatly reduce the costs of trading by judiciously selecting pertinent selling rules instead of selling a stock once falls off your buying screener. As well, the response time will be reduced as you do not need to wait months to react.
Which sell rules will you employ? I recommend keeping it simple and using a portfolio backtesting service to try your theories out. Of course the actual rules will depend on the stocks you trade - getting out of momentum stocks might have a close link to earnings growth, post earnings announcement drift, and price momentum while sell rules for a deep value Graham stock might something like a major drop in the current ratio, spiking price to earnings ratio or solely a market timing rule.
*You will need a stock screening and portfolio management service that allows for backtesting with separate buying and selling rules such as Portfolio123, but please leave a comment if you are aware of others (preferably that have free memberships)
Technical Trading Triggers
While some think that fundamental and technical analysis are opposing styles, there is no reason that they cannot be used in a complementary way. I am not generally a fan of using all sorts of technical indicators and short-term triggers but there are a few good long-term methods you may want to include. Here are a few:
- On a weekly or monthly chart put a trendline under the prices that are sloping upwards. As an example, if on the monthly chart for Coke (NYSE:KO) you see a serious price breach of the trendline such as a 6-7% price drop - you may want to reconsider your reasons for staying in Coke. Some sell when prices go parabolic and rise too fast as you can see when prices shoot straight up off the trendline.
- Very long-term moving averages. Some use the 200 day moving average as a general guide whether the stock is bullish or bearish. Some studies have found that very long moving averages work well when timing the broad market. I have also found the 350 day moving average to provide decent suggestions in some stocks as to when a sell might make sense. Using these in conjunction with trendlines might provide a better clue when to sell than just one method alone. (The chart below uses an 18 month moving average)
- Support and resistance levels. When a stock is well extended after making 3 or 4 thrusts upwards in a trend and reaching serious resistance - you may want to take some risk off the table. As an example - if you purchased Google (NASDAQ:GOOG) in 2010 around $475 and prices advanced toward resistance of $650, this could've been time to limit your exposure. When prices are consolidating or dipping down but strong support lies underneath, this might be reason to hang on a bit longer.
- One other tip as regards trendlines: Sometimes a new trend will move very rapidly. Trends do slow over time and consider drawing a less steep line after prices make a couple of bounces down to gain a more realistic view of the current trend. (See Apple (NASDAQ:AAPL) chart below with the steeper black line and the less steep pink one.)