The Most Important Decision to Make After You Buy a Stock

“You talked about the importance of taking small losses before they magnify into bigger losses,” a reader of The Safal Niveshak Post asked me yesterday. “But how do I know which stocks to sell to takes such losses? Is that so simple?”

“No, it isn’t,” I must say.

Knowing when to sell a stock or which stock to sell isn’t as easy a decision as knowing when to buy a stock.

In fact, most discussions on investing revolve only around when to buy a stock.

“Which stock should I buy?” is the first question that comes to your mind when you think about your investment.

But as we discussed yesterday, an equally important question is – “Which stock should I sell?”

Well, the answer to this question is often as difficult and individual as deciding when to buy a stock.

Philip Fisher, in his seminal book ‘Common Stocks and Uncommon Profits’ wrote, “If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.”

But then, there are times when the job is not done correctly and we realize later that the stock purchase was a mistake. It is then that a stock must be sold.

When to sell a stock?
Fisher suggests 3 reasons a stock must be sold.

1. When a mistake has been made
This is the most obvious reason to sell a stock – when you realise that it was a mistake to buy it in the first place.

When you realise that the actual background (business, performance) of the company is less favourable by a significant margin than what you had thought when you had bought the stock, it makes utmost senses to sell it.

Also, while you must sell your stock if you realise that a mistake has been made, the losses from that sale must never cause self-disgust. And neither should these losses be passed over lightly.

You need to review these losses so that you take a lesson out of the same, and do not repeat the same mistake in the future.

2. When a stock does not qualify to be held anymore
While this reason might sound similar to the first reason to sell a stock, it isn’t.

Instead, here we are talking about the good stocks in your portfolio. You must sell such stocks when, because of passage of time and due to fundamental changes in the companies, these stocks no longer qualify to be held anymore.

That is the reason you must run your investment checklist on your stock portfolio after a certain interval, say six months or a year.

If you realize that a company’s business has changed for the worse, like on any of the following factors, you must sell its stock.

1. The company is facing increased competition and has thus lowered the prices of its products or services;
2. The company is seeing a deterioration in its profit margins and/or cash flows;
3. The management has made a wrong decision – like entering an unrelated business – that will could negatively impact the company in the future;

There could be other reasons to sell a stock, but these are the most common and obvious ones.

If you find any of your stocks facing any of these situations, it will always pay to get out of the same.

3. When a better opportunity is identified
If you have made the right decisions while buying your stocks, this reason for selling stocks does not arise often. But in case you were to find a better opportunity in another stock than you find in any of your holdings, and you don’t have additional funds to deploy, it is a good idea to sell some of your existing stocks to reinvest in that better opportunity.

The stocks that you might decide to sell might still be good. But then the newly identified stock might be even better.

It’s like selling a stock where you expect annual average returns of 15% (which is good in absolute terms) to buy a stock where expected returns are around 20%.

But when you are looking to switch to a better company, return must be just one of your criteria. The new company must also pass your criteria of ‘great business at a bargain price’.

Never sell your stocks just because…

• You think a big stock market correction is round the corner, and that you must book profits on your stocks before the correction takes place. This is ridiculous. Like purchase of good quality stocks must not depend on what the general markets are going to do next, the decision to sell bad stocks must not be driven by this reason as well.

• The stock has become ‘expensive’. Well, this seems a logical reason on the face of it. But wait before you make any hasty conclusions. First answer, what is ‘overpriced’ or ‘expensive’? Won’t a good stock almost always sell at higher P/E valuations than a stock that has stable earnings that are not expanding? We hear the talking heads on business channels reciting their predictions for a company’s earnings for 1-2 years hence. And the confidence in their voice suggests that they are sure that their predictions will come true. But this is the case till the next quarter comes, and the earnings projections are revised, either up or down. And the same cycle of predictions begins. If the company has the potential to grow strongly that its earnings quadruple in another ten or twenty years, is it really of such great concern whether the stock is currently selling 30-35% overpriced?

• The stock has moved up sharply and that it cannot go up much further up. This reasoning seems right unless of course you are talking about an Infosys or an HDFC. An investor, who bought Infosys’s stock in December 1997 and sold it after it doubled in July 1998 or tripled in January 1999, must be ruing now. This is because the stock has multiplied 66 times since December 1997, even after accounting for the dotcom boom and bust, and after doubling and tripling many times. See, it’s impossible to find the next Infosys, or identify stocks that will go up ten-fold or twenty-fold. So it is good to stick with good stocks as long as the story is intact.

To repeat Fisher’s words, “If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.”

But then, it’s equally important for you to know when to sell a stock. And for that, you must have a proper, written investment strategy with a set of rules both for buying stock and selling stocks.

Such a written strategy provides the discipline to sell stocks before the losses blossom. And you know from yesterday’s discussion how taking corrective action before your losses worsen is always a good strategy.

You see, avoiding losses entirely may not be possible for any investor. But what separates successful investors is that they accept this and try to minimize their losses rather than avoid them.