Part of the challenge of kayaking is seeing the small rock ahead of you for what it really is – the tip of a massive boulder below the water's surface.
Stock investors have to spot potential hazards, too.
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"Buying and selling stocks is a lot about controlling risk," says Randy Farina, a senior portfolio manager with Exencial Wealth Advisors, headquartered in Oklahoma City. But knowing when to sell can be tricky. "It's not easy because there are multiple factors involved. Buying a stock might be easier than selling."
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Emotions can get the better of you. Selling when a stock is down can feel like you’re giving up, maybe too early. And selling when a stock price is rising can feel counterintuitive, even though it may be the best move. You can't time your exit in a stock perfectly. But some events can point toward opportune times to get out. We walk through five such situations below.
1. A Change in Fortune
In many cases, the decision to sell a stock should go back to why you bought it.
"Know what you own and why you own it," says Deborah Ellis, a Los Angeles certified financial planner. The reasons can vary: You bought a stock for its dividend payments, or its high-growth prospects or as a speculative bet. In any event, if the stock no longer fulfills its purpose in your portfolio, "it's time to sell," says Ellis.
The pros have a similar approach.
Stock fund managers typically build a case for every stock in their portfolio. It's often tied to a catalyst that will drive earnings growth, such as a new product or a company reorganization. If the catalyst fails to pan out, they sell.
Says Eddie Yoon, manager of Fidelity Select Health Care fund, a member of the Kiplinger 25 list of our favorite no-load funds, "It's straightforward for me. I thought a drug was going to work and it doesn't. The stock falls a lot, and I sell."
2. A Lofty Stock Price
It's hard to let go of winning stocks – typically, they keep winning because the businesses behind them are great. It takes discipline to take some profits off the table.
The folks at Altfest Personal Wealth Management, a New York City advisory firm, understand this. "There's a lot to like about Apple (AAPL)," says investment strategist and portfolio manager Mayukh Poddar. "It's a great business, its balance sheet is good, and it dominates its market." But in 2019, the firm began to reduce its holdings in the stock because it had become "quite expensive" on a variety of measures.
Figuring out if a stock is overpriced requires some work. You must develop a sense of what a business is worth, based on financial statements, the strength of its brand and the competition. It’s the kind of analysis that investors should do before they buy a stock, but often don’t, says Christian Koch, a CFP based in Atlanta.
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At a minimum, if a stock price is soaring, make sure that revenues and earnings are still increasing at a commensurate pace. The price-earnings (P/E) ratio is a popular gauge of how expensive a stock is relative to other stocks or to the broad market. The S&P 500 Index currently trades at a P/E of 21, based on estimated earnings for the year ahead.
Stock sectors have their own idiosyncrasies – financials trade at an average of 14 times earnings currently; tech trades at 24. Individual stocks can vary even more. A stock's high P/E might be justifiable, and a low-P/E stock might be no bargain, so it's important to consider other factors and other financial measures, such as the ratio of price to sales or price to book value (assets minus liabilities). An annual downward trend in any of these measures could signal a shift in the company's fortunes.
Some investors set a target – say, a 30% gain – and take their winnings when the goal is reached. That's not a bad strategy, says Ellis. "You never lose if you take a profit," she says.
3. A Falling Stock Price
On its own, a falling share price is not reason enough to sell. In fact, it might be a good time to buy. But if the drop in price is tied to a consistent decline in business results – revenues have been declining for more than two years, for example – exiting may be a good idea.
Some investors set a threshold for losses before they'll sell. If a stock falls 20% from his purchase price, Koch sells. "I manage real people's money, and my goal is to protect capital. If a stock falls 20% after I buy, I've obviously made a mistake. I sell and go to the next idea."
But Koch can be patient for stocks that go nowhere, another situation that prompts many investors to sell, sometimes prematurely.
In 2015, he bought shares in BlueLinx Holdings (BXC) when stock in the building-products company traded at $7 to $8 a share. "It was dead money for a long time," he says. But his long-term view was that when home-building stocks prospered, BlueLinx would, too. He was right. Koch sold the stock this year in the mid $40s.
4. A Dividend Cut
Dividends are sacred to shareholders and companies alike, so when a firm cuts its dividend, take note.
"It's certainly an attention-getter and a red flag," says Drew Lanphear, a Milwaukee CFP. "But it's important to dig deeper and find out what's behind it." Many firms pared or suspended dividends in early 2020 to conserve cash during the pandemic lockdown. But as the economy recovers, most of those payouts could be restored.
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Other times, a dividend cut can be a hint of bigger problems, such as too much debt or declining earnings, and you're better off getting out.
Shares in General Electric (GE) had fallen more than 40%, to $18, in 2017 when the firm cut its quarterly payout 50% in December of that year. Smart investors ditched their shares then – revenues had been relatively flat for years, and earnings were lumpy. Shareholders who hung on suffered more pain in 2018, when GE's dividend fell to one penny and shares slipped below $10.
5. A Portfolio Imbalance
Sometimes a good reason to sell shares has more to do with your portfolio than the company.
If your investment allocations are out of whack, you may need to rebalance by selling your winners and buying your losers to get back on track.
Or you may find a better investment.
When Fidelity’s Yoon discovers a new idea – "company B," he says – with a better potential reward for the risk than a current holding – "company A" – he'll sell some shares in A to buy B. "Keep in mind the overall goal: To capture the best ideas in a risk-adjusted way that can deliver the best compound returns," he says.
If you've decided to sell, unload your shares in smart ways.
For starters, sell in tranches over a period of time; Koch says he sells one-fourth of his shares at a time. Whether that happens over one month or several months depends on the market. "Sell on days the market is up to get the best price," he says. Don't assume you have to unload all of your shares, either.
"You can take profits in a rising stock, but not get out fully," says Yoon. "It doesn’t have to be a 100% or 0% decision." Remember to consider taxes if you hold the shares in a taxable account. (For more on tax-efficient investing, see How to Invest for a Higher-Tax Future.)
Finally, never sell in a panic. A business you were comfortable with in a smooth market should not be abandoned when volatility picks up. Says Ellis: "Don’t sell when the market goes down."
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