This article is a rebuttal to an article written by Bill Maurer entitled "Why Taking Profits Is Never Overrated". He argues that it is never a bad idea to sell a stock for more than you bought it for because a profit is always a good thing. In this article, I explain why this is not a sound investment strategy and provide some insight on how investors should look at their positions when they are in the green.
Stocks, bonds, and options are valued by the net present value of their future earnings or cash flows. There are no exceptions. The way investors beat the market is by identifying financial instruments, predicting their future cash flows, assigning a value to that asset, and then buying the asset if it is undervalued or selling the asset if it is overvalued. Nowhere in this fundamental, value-based strategy is there anything about what price the investor bought or sold the asset for in the past.
The tricky part about investing is that nobody can predict the future or perfectly predict the cash flows that will follow from buying an asset. There are also differences over how to value securities from asset class to asset class. Whether it's by future earnings for non-dividend paying stocks like Google (GOOG), future dividends for mature stocks like AT&T (T), the value of its underlying assets for commodity ETFs like SPDR Gold Trust (GLD) or distributable cash flow for MLPs like Plains All American Pipeline (PAA), no analyst uses what they bought in at to value any asset class.
There are three big reasons why simply selling out of a position just to make a profit becomes a poor strategy: lack of analysis, opportunity cost, and external factors.
By lack of analysis I mean the lack of firm, supportable data to make a good decision. For example, how do investors who bought into Apple (AAPL) early know when it is time for them to sell? It's definitely not whether they bought in at $50 or $300 because regardless of what the investor bought in at, it does not affect what the company is doing now and what they plan to do in the future to add shareholder value.
Apple shares have been able to climb so high because the company continued to beat earnings estimates and during most of the climb, the company had a very low forward P/E ratio for their already high growth expectations (which were beaten), and there was a huge pile of cash sitting around that never really worked itself into Apple's valuation until recently.
By opportunity cost I mean the cost of not weighing all of your options when you choose to sell a stock just because you already made a profit on it. By doing this without fundamentally analyzing the stocks you hold positions on, you limit the amount of financial decisions that you can make, which in turn lowers the maximum potential return that you can have on your investments. For example, if I close out my position on IBM shares just because I already made a strong profit on it (which I did), that's one less stock that I can invest in.
Even if there is still a lot of money to be made and all analysis and insight points to that, I lose out on the opportunity of buying an undervalued stock because I have already taken my profit and moved on. This makes me look for other investments that may not be as good or outside of my usual comfort zone, which leads to an opportunity cost.
External factors, like inflation and systematic risk, can lead to drawing bad conclusions when simply taking profits. For example, 2012 has been a very strong year for the stock market. The Nasdaq was up 18.67 percent in the first quarter and the Dow was up 8.14 percent. If an investor took a position in a stock in early January and made a 3 percent gain in the first quarter, this was not necessarily a good investment decision just because there was a profit. It is likely that the company underperformed and the gain stems from a strong market. If the investor interprets this 3 percent gain as a good investment decision and does not do their homework on why the stock did not do as well as other stocks on the market, he or she can get burned later on.
I would guess that over 90 percent of investors have sold a stock for the sole reason that they made a profit on it. The reason why people make this mistake is because there are sometimes external factors not related to fundamental analysis that may cause you to make a sell decision. The two big external factors are risk and new investment opportunities.
Risk is incredibly important when making investment decisions. Everyone who has ever taken a finance class is familiar with the CAPM model which demonstrates how higher risk investments demand a higher expected return. Although there are some exceptions, like gambling, and many financial scholars have their doubts on the validity of applying the model to real investing, it still does an excellent job of exhibiting how risk is one of the two most important factors when it comes to making investment decisions.
Many investors tend to sell stocks that they made money on right before earnings announcements because they don't want to risk a bad earnings call taking away their profits. Although the reasons for selling are wrong, the decision to sell may be sound because of the risk involved. I argue that an investor should sell the stock to avoid the risk of a bad earnings call even if he or she lost money on the shares. When this play pays off, investors believe that taking profits was the reason for the higher returns when in reality it was their risk averse investing strategy.
I recently sold Apple shares in a simulated portfolio that I maintain to see how my published positions on stocks perform against the market. In the portfolio, I bought into Apple as low as $363.88 and closed my position at $606.81. I did not sell because I had a good profit, I sold because I felt like there were now better opportunities in the market that I felt I should allocate my resources towards. If a stock goes up in value and all future estimates stay the same, odds are that there will be better investments out on the market.
Since there are these new investment opportunities, it is a sound decision to sell your current position and buy into new positions. I felt like it was a good time to sell Apple because the stock had another strong bull run and I believed the increase in future expectations made the stock more underweight. If Apple shares continue to perform well and outperform the investments I made from selling Apple shares, my decision to sell Apple will have been incorrect and taking profits would have been the wrong investment decision even if my new positions made a profit.
The stock market consists of hundreds of thousands of stocks so picking all winners is impossible. However, I believe that it is possible for Average Joe investors to beat the market. They can do this by consistently analyzing their positions and making investment decisions based on sound principles that have been universally accepted by scholars in the field of finance.
By implementing a strategy of "taking profits", I believe that investors are shortchanging themselves and limiting their arsenal of analysis weapons that will allow them to beat the market, which can cost investors big money in the long run.
Disclosure: I am long IBM.