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Course 504
When to Sell a Stock

Introduction

Just as there are no hard-and-fast rules as to when to buy a stock, there are no hard-and-fast rules as to when to sell. But investors typically spend a lot more of their time researching their stock purchases than they spend considering their selling decisions. Unfortunately, selling decisions are often made in the heat of the moment, after a stock has already taken a beating in the market. The best way to know when to sell a stock is to know why you own it in the first place. Did you love the company's fundamentals? Then you should know when they are changing for the worse. Was the company the industry leader? Then you should keep a close eye on the competition, and know when it is catching up to your company. Did you love the industry? Then you need to watch for an industry downturn. Did you buy the stock because it was undervalued? Then you should have a firm idea of what you think fair value is.

Don't Sell Based on Price Alone

You will be poorly served if you watch only your stock's price. When markets go through one of their periodic hiccups, investors who know why they own a stock are less likely to panic and sell after the stock has already tanked. In addition, there are the nasty tax consequences of selling frequently. By making sure every sell decision is justified, you'll inevitably cut down on capital-gains taxes. Avoiding impulsive selling decisions may be one of the best ways to improve long-term investment returns. While the decision to buy a stock is (or should be) the end result of an extended period of research, the decision to sell is often done in the heat of the moment, after a stock has already been crushed. But what good does it do to sell after the stock has fallen? Whatever the bad news was, it has already been incorporated into the stock price. At this juncture, investors should ask themselves: why they own this stock. Are the reasons for owning the stock still intact? If so, the more rational reaction to a dropping stock price might be to take advantage of the lower price and buy more. Likewise, investors may actually sell off a gem of a stock just because it has had a great run. But myriad examples show that a great company can outperform the market year after year. The fact is, most of us would be better off if we could block out all those graphs of past stock performance, since they convey no information we can use profitably in the here and now.

Know Why You Own a Stock

So if today's price isn't a good indication of when to sell a stock, then what is? Know why you bought a stock, and why you still hold it in your portfolio. If you bought a stock because you liked the fundamentals, you had better keep an eye on the company to see that these attractive fundamentals remain intact. Unfortunately, it is sometimes tough to distinguish between normal fluctuations of a business and long-term shifts in fundamentals--the trivial from the weighty. If Computer Associates CA misses analyst expectations by a penny because of a change in foreign-exchange rates, for example, you really don’t care unless the company's long-term prospects are somehow impaired. But if there is a fundamental change in an industry or individual company, the reasons you bought the stock may no longer hold true. In 1996 or 1997, you might have bought PeopleSoft PSFT because of its stellar growth and long-term potential. But as the market for such systems became increasingly saturated, growth at these two companies slowed, and they are no longer the growth stories they once were. You may still want to own these stocks, but maybe as value plays, not as stellar growers. You may also sell a stock if you find flaws in your initial analysis. You may have missed something when you were doing initial research on the stock, or there may have been something that you couldn’t have known. Hopefully, if you keep up with your stocks, you will realize your mistake in time to get out of the stock before the price takes a hit. But that's not always the case. Finally, if one of your stocks has taken a big hit (or even a series of small hits) and you're not confident in the company's prospects, be willing to cut your losses and sell the stock. There is no law that says you have to hold onto a loser until you break even. Selling at a loss can also help offset capital gains elsewhere in your portfolio.

When You Should Sell Based on Price

Investors don't always buy a stock because they love the long-term story. Often, they will pick up a stock with just average fundamentals but that is clearly undervalued. If you buy a stock not because you love the company, but because its stock is cheap, then you should keep a much closer eye on valuation. Unfortunately, no hard-and-fast rules exist on when a stock becomes too expensive. That's why many investors fall back on simple rule-of-thumb cutoffs, such as P/E or PEG ratios. While this strategy can sometimes cause investors to miss out on a great run, firm cutoffs can force investors to be more disciplined--and to spend time examining investments that may have better future prospects.

Quiz 504
There is only one correct answer to each question.

1 When is the best time to sell a stock?
a. When its P/E is more than 25.
b. When the conditions that drove your decision to own the stock no longer hold true.
c. When the stock has been beaten up.
2 What should you watch when deciding whether to hold or sell a stock?
a. Just the price.
b. Just the fundamentals.
c. It depends on your reasons for owning the stock.
3 If you decide that a stock purchase was a mistake, what should you do?
a. Hold onto it anyway and hope for the best.
b. Admit your error and get out of the stock.
c. Short the stock to cancel out your position.
4 If a stock has been beaten up by the market, you should:
a. Buy more. If you liked it when it was more expensive, you should love it even more now.
b. Sell it. Why should you hold on to a dog?
c. Examine why the stock was beaten up by the market.
5 Stock price should be the key to your selling decision when:
a. You bought the stock primarily because it was undervalued.
b. The company's fundamentals are fantastic.
c. The stock has been beaten up.
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