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Morningstar.com's Interactive Classroom

Course 112
Know When to Sell

Introduction


The last of Morningstar's Four Principles of Profitable Investing is "Know When to Sell." Despite the examples highlighted in Stocks 111 about the mathematical advantages of being a long-term investor, there's something we didn't mention: Knowing when to sell is a key part of successful investing. As Kenny Rogers would say (or sing), "You gotta know when to hold 'em, and know when to fold 'em." He was referring to a game of poker, but the same could be said of stocks.

Even long-term investors have to sell eventually because very few stocks are "hold forever" stocks. Knowing when to sell is difficult, and there is a fine line between being in the market for the long haul and making short-term decisions about whether or not to sell.

Part of the problem is that investors are inundated with advice about which stocks to buy, but sell recommendations are as rare as reliable Elvis sightings. Wall Street sure isn't providing any help, though. According to the Financial Times, even with the increase in "sell" and "hold" recommendations recently, explicitly negative recommendations still account for less than 2% of the more than 25,000 analyst notes in circulation. Telling investors to stay away is just not in Wall Street's best interests.

But there is hope….

Four Reasons to Sell


By studying the writings, interviews, and investment styles of great investors, Morningstar has gleaned some insights that can help investors solve this dilemma. As it turns out, there are really only four good reasons to sell a stock:

1. You realize you made a mistake buying it in the first place.
2. The stock is wildly overvalued.
3. The fundamentals of the company are deteriorating.
4. You need the money for a specific purpose, such as a new house or to cover living expenses after a job loss.

Reasons Not to Sell


Before we explain the four good reasons to sell a stock, let's cover some of the reasons you shouldn't use to justify cutting a stock loose. First, just because a stock has gone up doesn't mean you should sell it. A whole host of factors go into this decision, such as tax considerations and your personal financial situation. Suffice it to say that in most cases it's better to hold onto a stock that's gone up than to sell it.

Also, you should try valiantly to avoid the mistake most beginning investors make: selling their winners while holding onto their losers. Human psychology comes into play here. We humans hate to admit when we've made a mistake. Therefore, lots of investors hold onto stocks that have gone down with the hope of selling them as soon as they get back to the "break even" point. If they need to raise cash, they sell one of their winners instead.

Unfortunately, in most cases selling your winners is exactly the opposite of what you should do. After all, the U.S. tax code gives you a write-off for realizing a loss, so why not take advantage of Uncle Sam's generosity whenever you can?

The thing to always keep in mind is that it doesn't matter what a stock has done since you bought it; there's nothing you can do to change the past. But you can change your future by selling a dud and taking the tax write-off. Think twice about selling those winners, though, because in most cases the reason they're winners is that they've beaten expectations, and this is often a sign of a company building an economic moat.

More on the Four


Sometimes, you do have to sell even your winners. If the fundamentals of a company begin to deteriorate, you may want to consider getting out of the stock--even if it's made you a lot of money in the past. You also might also want to sell a stock if it goes up so much that it's wildly overvalued by any reasonable metric. For example, Yahoo was once selling for around $200, (close to 200 times sales), and it was nearly impossible to make a logical argument that the stock was fairly valued. Investors who held the stock as it went from $2 to $200 in the previous three years would have been smart to take some money off the table.

Still, the number-one reason to sell a stock is if you made a mistake in the first place. Suppose you bought stock in what you thought would be a solid, fast-growing company, but it then turned into a debt-ridden company fighting to save its life. If you would not buy into a company in its current incarnation, why would you hold it? Everyone makes mistakes, but we've found that all great investors are self-critical, quick to realize their mistakes, and not afraid to cut their losses.

An important point here is to not worry about missing a stock's peak. No matter how savvy you are, there's no way you can consistently pick the top (or bottom) of the market. There's a saying on Wall Street: The only person who always buys at the bottom and sells at the top is a liar.

Quiz 112
There is only one correct answer to each question.

1 Which of the below is the best reason to sell a stock?
a. It's gone up 30% over 3 weeks.
b. It's gone down 30% over 3 weeks.
c. The reason you bought in the first place no longer applies.
2 According to Financial Times, approximately what percent of Wall Street analysts reports are explicitly negative?
a. 50%.
b. 10%.
c. 2%.
3 Which of the following is a mistake many novice investors make?
a. Selling their losers after a company's financial health deteriorated.
b. Holding onto their winners after a company beat financial forecasts.
c. Selling their winners just to lock in gains.
4 Suppose you bought stock in a restaurant company that you thought had good growth prospects. But your tastes appear to be different than the rest of the country's, the restaurants flop, and the company uses what little cash they have left to get into coal mining. You should consider…
a. Buying more.
b. Holding.
c. Selling.
5 Which of the following is NOT one of Morningstar's Four Principles of Profitable Investing?
a. Knowing When to Sell.
b. Find Companies with Economic Moats.
c. Buy at a Premium to Fair Value.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
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