When is it the right time to sell a stock?
That’s the single most difficult question for an investor to answer. It’s something that both professionals and retail investors struggle with.
Do you take profits? Cut losses? Hold “forever” as Warren Buffett recommends for his favorite stocks?
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There are different schools of thought here, some fundamental and some technical. The answer can also vary depending on the investor’s situation, but there are certainly some best practices to keep in mind.
Let your winners run
If a stock is performing well, the underlying company is healthy, growing and profitable, and you don’t need the cash, there is no need to sell it. Let it run.
If you started a profitable hamburger stand, would you sell it if you started selling more hamburgers than you originally thought possible?
Of course not. You’d let the business run and listen to the sweet sounds of the cash register ringing. Why should a stock be different?
A fundamental investor – think Warren Buffett – might decide to sell a stock when their opinion of the business’s prospects changes. If they believed that its best days were behind it or that its price could not be justified by business fundamentals, then selling it would make sense.
But otherwise, there’s no real reason to sell a stock if it’s performing well. Let it run and allow earnings compounding to work in your favor.
Cut your losers
Of course, not every stock is a winner. Some investments don’t work out the way you wanted them to. And when they don’t, you need to have a plan in place for when to dump them. (Though, remember, that tax-loss harvesting, or selling a losing stock position, can help lower your tax bill.)
Small losses along the way are rarely going to hurt you. But even a handful of large losses can obliterate your portfolio returns.
Using a stop-loss order is the most straightforward way to make sure that a loss stays manageable. When you set a stop-loss, you instruct your broker to sell a stock if it hits a certain price.
For example, let’s say you own a stock that’s trading for $10 per share. You’re willing to risk up to $2 per share. So, you place a stop-loss order with the broker with a stop price at $8. If the shares fall below $8 per share, the broker will execute a market order at the current market price.
There is no universally agreed-upon criterion for how to set a stop loss. William O’Neil, the founder of Investor’s Business Daily, recommended always selling a stock when it dropped 7% to 8% below your purchase price.
Other investors prefer to use a “trailing stop” based on a percentage. For instance, you could set a trailing stop to execute if a stock fell 10% below its highs.
Back to our $10 stock example, let’s say the stock rose to $15 before turning around and trending lower. If you had a 10% trailing stop in place, your broker would execute a market order if the stock dropped to $13.50.
There is an art to setting the perfect stop loss. You want it to be wide enough to allow for normal “wiggle room” in the stock price, but tight enough to protect you from significant downside.
Most online brokers allow you to set stop-loss and trailing-loss orders on their platforms. Fidelity, for instance, offers the option to set an exit plan for the positions in your portfolio, where you can choose between order types, including a stop loss and a trailing stop.
You’ll want to check with your specific broker.
Controlling risk
As we covered, if a stock is performing well and trending higher, you generally have no real sense of urgency to sell it.
The only exception here would be if one stock performed so well that it has grown to become a disproportionately large piece of your portfolio. In this case, selling a stock to rebalance your portfolio may be something to consider.
If your stock trading account is small relative to your larger accounts, such as your 401(k) plan, it’s probably not a major risk to your financial health if one or a small handful of stocks grow to dominate your account.
But let’s say that a substantial portion of your entire net worth is tied up in just a couple of large stocks. You don’t immediately have to sell a stock because it’s grown to dominate your portfolio, particularly if it’s still performing well. Doing so could generate unnecessary capital gains taxes.
But you should have a plan in place to sell, even if you don’t execute it right away. It’s important for investors to have a risk management plan in place in case things take a turn for the worse.
This can be done by initiating a series of stop-loss orders to sell a portion of the stock at certain thresholds versus unloading the position all at once.
Perhaps the best advice is to resist the urge to get emotionally attached to a stock. Remember, no matter how much you love a stock, it will never love you back.
The more emotionally entwined you are with a position, the more likely you are to lose your objectivity and talk yourself out of selling or, on the other hand, unloading the position sooner than you would have liked.
Ultimately, you want to make the decision to sell a stock as mechanical and by-the-numbers as possible, and ensure that it aligns with your investing goals.