A question as old as time in the stock market.
How do you know when to sell a stock?
If you ask an investing great, they will likely say something to the effect of:
“the best time to sell a stock is never.”
In fact, I think Warren Buffett said that one already.
But the reality is that sometimes our stocks don’t always work out. And the reason for that is because the business world is so unpredictable. And competitive.
There’s a lot to unpack in the question of knowing when to sell, and I’ll try to cover as much as I can here. We’re going to try and answer this question by talking through these key points:
- Knowing When to Sell to Avoid Losses
- The Basics (and Flaws) of the Trailing Stop Loss
- When To Sell? It’s In the Fundamentals
- When to Take Profits? A Very Personal Question
First, let’s talk about the dark side of investing—losses.
Knowing When to Sell To Avoid Losses
Whether a company does well or poorly in the stock market, it always appears obvious after the fact. This is a well-known behavioral bias known as hindsight bias.
For example, in hindsight, it’s easy to say that Apple was an easy investment to make 20 or 30 years ago. After all, it seemed like everybody had an iPod and, later, iPhone, so of course, it’d eventually become one of the best companies on the planet.
Plus, Steve Jobs was an obvious savant, parts great leader and brilliant artist; investors would be foolish to pass up on a company like that, right?
Well, actually, back when Apple was very young (it used to be called Apple Computer, imagine), Steve Jobs didn’t really have it all figured out as a CEO and leader.
In fact, Jobs eventually was booted out of his own company, no longer owned a single share, and the stock cratered like you wouldn’t believe.
Even in the post-Jobs era, I remember Apple being a hot topic not because they were a great stock, but because they were a disappointing stock. Why? Because they had too much cash!
I’m not kidding you. Apple used to get a ton of heat for keeping lots of unspent cash abroad, and the stock was never that popular until recently. Apple didn’t do what analysts wanted, and the stock paid the price temporarily. Warren Buffett was smart enough to see it at the time and took a large stake, most of us, unfortunately, wasn’t.
This Apple example is a great illustration of how hindsight bias is a tricky beast.
Because of hindsight bias, we think we can perceive the future much more accurately than we actually can.
So it can be easy to think that’d we’ll easily perceive trouble ahead and sell before it happens—reality is often much crueler.
Some investors try to work around the problem of hindsight bias and of not knowing when to sell a stock, by setting rules for selling based on a stock’s performance, such as a trailing stop loss.
The Basics (and Flaws) of the Trailing Stop Loss
The logic behind the trailing stop loss is simple, you ride the stock up, and sell it when it starts going down.
For a simplified example, say you have a stock trading at $50. An investor who sets a 10% trailing stop loss will sell that stock if it drops 10% (to $45) or more. It “trails”, because as the stock goes higher so does the stop loss, or time to sell. If the stock trades at $60, the trailing stop loss rises to $54, which is 10% less than $60.
You can see how this strategy would allow you to ride a stock up and then sell as it reverses trend and moves down.
The problem is that stocks don’t perfectly uptrend and downtrend over time.
Some of the best-performing stocks of all time have had huge drawdowns (losses), yet that doesn’t necessarily make them a great time to sell every time.
An example I like from the book 100 Baggers by Chris Mayer talks about Monster Energy, which eventually reached 100 baggerdom (its total return was over 100x).
Monster routinely had months with -20% performance followed by 20% gains. An investor with trailing stops on a long-term buy-and-hold strategy in Monster would never have earned 100x, even though it was a fantastic company!
You’re cutting yourself off at the knees if you’re setting trailing stops in order to direct your selling decisions. This is because the stock market is volatile whether a company is actually performing poorly or not.
In other words, the market doesn’t know the difference between being spooked and being spooked for a good reason. It crashes red either way.
Take some stock market crashes from history as an example.
It’s pretty routine for the stock market to crash 25% or more in a short period of time. They are so common that they have a name—corrections.
You could make the argument that trailing stops make a great answer to knowing when to sell a stock because they would’ve kept you from a bear market, like 2008…
But what if you had used the same logic during the Black Monday Crash of 1987?
A crash like that would’ve triggered most everybody’s trailing stop, and yet the market recovered and just went straight up for a long time after that! What an awful time to be “stopped out” of the market.
When To Sell? It’s In the Fundamentals
Something that Dave really helped me internalize when it came to knowing when to sell was a very simple question,
“Have the long term fundamentals of the business changed?”
This is such a simple but profound question.
Because at the end of the day, buying a stock is really about becoming a part owner of a business. If you want to see success over time, you should be “partnering” with the business for the long term and letting it do the compounding for you.
You see, a true long-term owner doesn’t care what’s happening in the markets or how much other people think their business is worth.
The great father of value investing, Benjamin Graham, composed a euphemism for the stock market as Mr. Market. This character is a manic-depressive appraiser of businesses who offers you a new price every day.
If you are an owner of a business with fabulous profits which are compounding at an attractive rate, why would you sell a great asset such as this?
Or in other words, why kill the golden goose?
Why Kill The Golden Goose?
What Mr. Market says your wonderful little business is worth means little to you, as long as you’re receiving an attractive rate of compounding of capital within the business.
Looking at it in that mindset, we should look instead at if the business is compounding capital like we want rather than if Mr. Market is manic or depressive in any given day.
So how do you know when a business’s fundamentals changed? How do you know when the fundamentals warrant when it’s time to sell the stock?
That’s a much harder question to answer, but I’ll give a few examples.
For one, I like to have a good understanding of what makes businesses fail so that I can identify situations like that and run from them.
Like Charlie Munger says,
“all I want to know is where I’m going to die so I’ll never go there”.
With that kind of curiosity, I did extensive research into stock market bankruptcies in the 21st Century and looked for any sort of good signals that tended to preclude bankruptcy.
I found an extremely strong signal—negative earnings.
Increasing debt to equity was also a common signal; both of these conclusions make sense.
So for me, I took these findings and made a couple hard and fast rules based on them, and they’ve worked out well for me so far.
One notable and somewhat controversial one: sell a business with negative earnings.
This is a simple indicator for when it’s obvious to me that a business’s fundamentals have changed, and that’s how I know when to sell a stock.
If you can start to understand what it is about a business that makes it tick, what it is about the numbers of a business that tells you how it is performing, what gives a business its competitive advantage, what are the true risks—those are the right questions to be asking!
Asking how you know when to sell a stock is a good question. Asking, how do you know when a business’s fundamentals have changed for the worst is a much better question because in answering it you can answer the first question.
There’s no magic formula or solution to answer this because every business is different.
I know that’s not what you want to hear, but we have a few resources to help you.
You’ll want to start really understanding a business by reading its 10-k. You’ll want to develop a circle of competence by reading about a business and its competitors and how their industry works. You’ll want to further cement your knowledge on their positioning and potential signals of competitive advantages by building an industry map.
Those are the ways to understand the fundamentals of a business, which helps you understand when those fundamentals have changed.
When to Take Profits? A Very Personal Question
Alright, well maybe we’re not all as risk averse as Andrew.
Maybe we’re super optimistic, or want to see the endgame. We want to visualize piles of cash and huge capital gains.
That’s great too, and let me just say that knowing when to sell an outperforming stock is a fantastic problem to have.
However, I’ll advise you with one main idea today.
Number one, I love the advice by Charlie Munger about when to sell a stock, it goes something like this:
“The first rule of compounding: Never interrupt it unnecessarily.”
The reality of the greatest stocks of all-time is that they’ve been the greatest for a very long time, sometimes even many decades.
Even one of Buffett’s greatest investments, Coca Cola, was already THE #1 stock in terms of outstanding performance for decades before Buffett bought in. In fact, it reached (one of) its heydays during the World Wars; Buffett bought it in 1987! The reason the ticker is $KO is because the stock was a “KO” investment, it knocked the lights out of everything else.
So if you were an investor in the 1940s or 1980s or any of their great decades and you sold to lock-in your profit, you’d miss out on fantastic compounding for many years!
We buy businesses so we can reap the rewards of their work, not so that we can work hard to try and predict the future.
The ultimate goal for many of us is financial freedom, and so ideally that means that we can live off our portfolio without having to draw from it.
For me, that looks like getting paid dividends to spend and enjoy while my shares remain intact.
If that’s the ultimate goal, then why even think about taking profits? As long as the fundamentals of a business have not changed, who’s to say the company can’t continue to compound capital at high rates for many more decades like $KO did?
Who’s to say that a stock can’t provide income, which is more than enough to quench my need for profits or gains?
That’s what it looks like for me, and why I say that knowing when to sell a stock to take profits is a personal choice.
If you want to take profits just to take profits, that’s up to you. There’s many good arguments for taking profits early rather than late.
But I’ll just say if there’s more to your investments than taking profits then maybe you should reconsider that. Because the great thing about compound interest is that it works in the background constantly, and the less profits you take the more it can work and multiply.
Andrew has always believed that average investors have so much potential to build wealth, through the power of patience, a long-term mindset, and compound interest.