When to Sell

The best answer to the question, “When to sell?” is never. If an investor exercises the same care in buying shares of stock in a company that he/she would use if buying the whole business, then those shares might never be sold. The great advantage in this happy circumstance is that gains compound without the penalty of capital gains taxes. Indeed, if they end up in the investor's estate, they have a whole new cost basis for heirs.

Realistically, we cannot expect to never sell even though this can be a theoretical goal. Most investors will make sales during their investment careers and those sales often represent a tough decision. In fact, the average investor finds a sell decision much tougher than a buy decision. Buy decisions usually occur when excess cash is present and simply represent choosing between an attractive new idea or adding to an existing position. There are really only four reasons for selling an investment.

Unambivalent Need

The first reason is the least complicated and, in most instances, the least ambivalent. This occurs when the money is needed for another purpose such as buying a house or paying for college expenses. Often this represents a happy event both unto itself and because it is the fulfillment of a disciplined plan. It can give satisfaction of a job well done. Even so, there may be accompanying sadness because there can be more joy in the journey than in arriving at the destination. Unfortunately sometimes a sale is forced by illness or job failure. While the afflicted individual is grateful for his reserves the whole experience is fraught with loss—loss of income, prestige, health, and self-esteem.

A Clear Mistake

The second reason for selling is when it is clear a mistake has been made. This occurs when a company's fortunes have gone awry. This is an extremely difficult decision for most people because acknowledging an error is a painful narcissistic injury. Many investors try to avoid this through the familiar defense, “I'm waiting for it to get back to what I paid for it and then I'll sell.” This is the psychological mechanism of undoing as we deny our mistake and try to undo it. It is far better to act quickly when an error in judgment occurs. The use of stop-losses can help in dealing with this problem. If a company does not fulfill an investor's criteria for a permanent hold (in which case he would happily buy more in a market decline), a stop-loss should be determined at the time of purchase. A good example of an effective use of this investment tool is in a speculative purchase where anticipated good news fails to materialize. The stop point should be chosen either based on the size of loss that can be financially and emotionally tolerated or by studying the stock's chart and selecting a stop point just below a key support level.

A Superior Replacement

The third reason for selling is when you believe you have found a superior investment. This is often coupled with a rise in price of your original investment to a point where you now judge it either to have fulfilled your objectives or to a point where you believe it to be very overpriced. This is a tough call because who is to say that a stock the market has overpriced might not go ahead and become even more overpriced. Furthermore, excellent long-term investments do frequently get overpriced temporarily just as they are periodically under-priced. There are times Berkshire Hathaway* declined 40-50 percent from a new high. How foolish it would have been to try to jump in and out of it.

Matured Into Obsolescence

The fourth case of when to sell is when, in your judgment, a company has reached its maturity and while still a reasonably good company just does not meet your criteria any longer.

All decisions to sell are complicated by tax considerations. It is far easier to make sell decisions when trading in a tax-advantaged account like a Keogh, IRA, or self-directed pension account. In taxable accounts, the investor must ask the question, “After I have paid my capital gains tax, at what rate must my reinvestment outperform my original investment to justify my switch?” Consider an investor owning Exxon stock with a cost basis of $2 a share. If $10,000 of Exxon stock is sold, the after tax proceeds will be $8,300 (after federal capital gains tax but NOT including applicable state taxes). I make the assumption Exxon's long-term total return (dividends plus capital gains) will be 9% compound per annum. If the investor reinvests at 12% compound per annum, (by no means an easily achieved rate), it will take five years just to catch up. Finally, it must be considered that even in the happiest of sale circumstances, for instance selling at a big gain to purchase something long desired, there is some psychological experience of loss. From the first moment of purchasing a stock, we begin to imbue it with positive qualities. We identify with it and its management. We derive pleasure from its success. If its price rises substantially with time, our sense of value and narcissism rises, too. Thus, when we sell, we experience some loss even under optimum circumstances. The oddest of all these loss feelings is the lost fantasy that the stock will soar after our sale. Thus, we can conclude that sell decisions are often psychologically complex and must be mastered to be an effective investor.