Much is made of stock buying strategies, but the truth is nobody makes a dime from their investments until they sell. Selling stock is easy – knowing when to sell maybe not so much. Or is it?
It certainly should be.
Ben Graham variously suggests keeping stocks for 2 years, and/or selling 50% of a holding. Warren Buffett hardly ever sells, if ever. Buffett is no ordinary value investor in that he buys entire companies, not just hundreds or thousands of shares of stock. For the majority of individual investors, there are probably only a handful of selling strategies in use, most of which are more or less random depending on their emotional state.
- Sell after X amount of time.
- Sell when I need the money.
- Sell when I’m in profit and the tax consequences are minimal.
- Sell to record a tax loss when you file your online tax return.
- Sell this stock because I don’t like it anymore.
- Sell because my original investment is 10 percent, 50 percent, even 90 percent gone. Ouch!
- Sell because EPS missed estimates by one measly cent.
- Sell because today is as good a day as any and my gut says so.
And so on. You get the picture, more often than not there’s precious little logic involved.
Then there is a selling strategy that starts with the process of buying and is built into an overall goal for your portfolio. As you analyze XYZ stock for purchase – because you have determined it to be undervalued and with an adequate margin of safety – before you even pull the proverbial trigger you wonder out loud: at what price will I sell this stock?
The simple answer might be: when it reaches fair value. But life is never simple in investing. When will XYZ get to fair value? Will it ever? Will I still be around when it does?
A better answer might consider the fact that you have a set target for your entire portfolio to make an annualized return of, say, 20% per annum. You can then give each of give your individual purchases a set amount of time to make a profit, say 20% each in any one year period. Suppose you buy 5 stocks at the beginning of the year, investing one fifth of your portfolio in each. If 3 of your 5 stock purchases should make a tidy 50% gain in 6 months (the other two staying flat) and you sell them at that point, you can afford to lose 25% on your other two purchases by the end of the year and still meet your portfolio’s annual 20% percentage gain goal. Should the other two purchases remain flat through year end, your portfolio gain for the year is 30%, comfortably beating your target.
I like to think of maintaining my personal CAGR or Compounded Annual Growth Rate over the years. This means I pay attention to annualized gain and sell early winners, or at the very least lock in profits with trailing stops. That, in turn, means I can give the laggards more time.
If a stock gains 20 percent in a year thats the annualized gain for the year. If the 20 percent gain happens in the 30 days after buying, the annualized gain is way more than 20%. We can extrapolate to find the annualized gain from our 30 day period gain as follows:
((1 + Rate of Return)^1/N) – 1
N = Number of periods
Since our gain happened in 30 days, we calculate N as 30/365= 0.08219178
(( 1 + 0.20)^(1/0.08219178)) – 1
(( 1.20 )^12.1666667 ) – 1
9.19119181 – 1
8.19 or 819%
The longer we get to a full year, the lower the annualized gain becomes. That 819% will diminish exponentially unless the stock continues to gain at the same rate.
In simple terms, sell after 2 years any stocks that have gone nowhere or contributed less than your target CAGR. Lock in profits on those that go up steeply, or sell a percentage such that your remaining stock is free. Or sell if they have already reached fair value and you have found something else that’s undervalued.
What about stocks that go down? If you calculated your margin of safety well, you shouldn’t have too many of those, and your personal CAGR should be boosted enough from the winners and good years that you can ride out any losers while maintaining that minimum rate of return.