Knowing when to sell your stocks is much harder than most people think. You can spend all your time researching which stocks to buy and when, but if you don’t have a sound sell strategy then you can miss out on a lot of big gains.
You could sell too soon and miss out on a rebound. Or, you could sell too late and not see any gains. There is more regret about when to sell than there is on buying the stock. The sell side is so overlooked, and to be a good investor you must at least think about it.
The first thing to realize is that you never want to sell your stocks just because it has been underperforming. I have mentioned this before, and I must explain it again. A successful stock strategy will buy low and sell high. When you sell out of a stock just because it hasn’t been “a good stock”, then you are locking in your losses and selling low.
This is easier said than done, but that is why you want to make sure you’ve done your research. A stock price may fall because a company misses earnings and/or has a subpar quarter or year. Low temporary earnings will cause the stock price to fall because everyone thinks the company isn’t as strong as it used to be.
When to Sell? Not Because of Bad Performance.
But you need to know the difference between temporary underperformance and actual warning signs. If a company has a sound balance sheet and can endure temporary underperformance, then you can be confident that you don’t need to sell low. As long as you have bought the stock when it had good valuations, you should be fine.
Signs of a strong balance sheet
1. Low debt to equity ratio
2. Evidence of earnings growth
3. Decent yield on the dividend and low payout ratio
Examples of Good Valuations
1. P/E around 15
2. P/B around 1.5
3. P/S around 0.8
4. P/C around 10
Examples of Actual Warning Signs
1. Complete cut of the dividend
2. Substantial increase in the debt to equity ratio
3. A year of negative earnings
A sudden extreme increase in P/E, P/B, P/S, P/C may also be a red flag but this tends to happen as a stock gets higher instead of lower. To learn more about the details of these valuations and why they are important, check out my Investing for Beginners guide. You can get this guide, plus real life examples, by subscribing for my free eBook found in the sidebar and at the end of this post.
So, do you now know how to prevent yourself from selling low? You should, and you should only be wanting to sell high. It’s a little backwards, to think you want to get rid of the stocks that have been treating you well and hang on to the stocks that have been slapping you in the face.
In fact, you should be taking the money you’ve made from your good stocks and use them to buy more of a stock that hasn’t been doing well. Again it’s counterintuitive, and harder to do than to say, but it will bring you the most profits. The truth is that stocks fluctuate like the seasons do. When you are buying at the lows and selling at the highs, you will be doing the opposite of what everyone else is doing and saying to do.
Don’t get me wrong, I am not telling you to try to time the market. But, you must look at your portfolio and the stocks on your radar and time those individual investments by buying low and selling high. Take some profits from a stock that has been winning for you and add more to a stock that has been underperforming but has no actual warning signs.
You might be thinking, how do I know when to sell my profitable stocks?
The answer is: You don’t. But you can use a common sense strategy to prevent yourself from greediness while avoiding regret all at the same time.
The Key to Taking Profits
The way I lock in profits is to first determine how much I want to make from a stock. For me, I shoot for 15%. I figure that the average yearly return is about 7%, so if I can double that in a short time frame then I’ll happily take those profits.
So, what I do is establish a trailing stop on my profits. A trailing stop creates a floor for my stock, and if the stock hits that floor then I sell to avoid losing any more. It may be hard to visualize but I’ll do my best to explain.
Say my stock is at $15, and I have a trailing stop at 10%. That means if the stock falls 10% to $13.50 then I sell and no more losses take place. The beauty of the trailing stop is that it follows your stock up. So if that same stock at $15 is rising in a consistent manner, then my trailing stop is following it up the whole way.
If the stock shoots up to $20, the trailing stop is now $18 (10%). If it keeps riding higher, the trailing stop continues to follow. Then once the momentum stops and the stock moves down the other direction, my trailing stop ensures I lock in all my previous profits.
Trailing stops are great for locking in profits because they let your stock ride. It prevents you from selling too soon and lets your stock continue its momentum without trying to time an exit point. Many investors like to use trailing stops to both limit losses and lock in profits. I only like to use it for the latter.
2 Caveats to the Trailing Stop
1. I only activate my trailing stop when my stock is up 25%. I set my trailing stop at 10%; set to 15% if gains > 30%.
The reason for this goes back to what I said earlier. I am happy with at least a 15% gain in a short period of time. So if my stock is up 25% and my trailing stop is at 10%, then the very least I will gain will be 15%. Do you see how that works? So no matter what happens, I am happy with the result. Trying to take profits less than this would incur too many trading costs from too many trades.
Don’t try to micromanage your portfolio, let the price fluctuate and only sell when you have a profit you are happy with. This is also why I don’t use a trailing stop all the time. My focus is long term investing, as yours should be too. With how much volatility is in the market, why would you let a temporary stock price correction negatively affect your portfolio when it probably will rebound in the future? Again, it all comes back to if you’ve bought when the stock had good valuations and there are no actual warning signs with the stock, then you aren’t sweating when the stock price falls.
Undervaluations will rebound and correct back up eventually, and it is with this patience that you will be rewarded. A trailing stop, however, would force you to sell on bad news and prevent you from being patient and riding out the lows. That is precisely why I only activate a trailing stop for gains.
2. I only sell my gains [not my entire holding] when a trailing stop is activated.
This second part also prevents us from having regret. When a stock is looking good, it may have a temporary pull back before continuing to climb higher. If you were to sell everything when the trailing stop was hit, then you would miss out on the further climb.
You shouldn’t sell a stock just because it has gone higher. Use this strategy and implement the trailing stop, but only use it to sell your gains. As long as the stock discussed still has decent valuations and a strong balance sheet [and remember, no actual warning signs] then we should only be taking some profits but letting the rest ride. Just because a stock has gone higher doesn’t mean it still isn’t the best place for your money.
This strategy helps you to compound your gains while at the same time still being invested in a stock that has proven to be a winner. You should be proud of yourself for finding such a winner. Don’t punish yourself by no longer holding that stock!
Keep your principal in there and let your profits ride elsewhere. That way you are compounding your returns, and always are completely invested in the market.
Doing this gives you the greatest advantage, and that is being a long term investor.