In our last lesson, we looked at a 5-point checklist you should consider before buying a new stock. The goal there was to make sure your new stock passed ALL five points before being admitted to your portfolio.
Today, we’re going to look at the other side: When should you sell a stock in your portfolio?
Too often investors look at their own gain or loss as the sole deciding factor in when to sell.
It’s important to remember that your personal gain or loss on a position has nothing to do with the future prospects for the company. The stock is a good or bad investment regardless of how much your personal position has changed in value.
This checklist is different from the “when to buy” checklist in one important way:
When using the 5-point stock buying checklist, you should be able to answer, “Yes”, to ALL five items before buying the stock.
However, with the stock selling checklist, you can sell a stock anytime you answer, “Yes”, to ANY of the questions below.
Unlike buying a stock, you don’t have to satisfy ALL the different possibilities below. ANY one of them is reason enough to sell the stock and move onto something better.
As usual, this isn’t a fully exhaustive list of reasons to sell. But we believe it covers all the most common and important cases.
We’ve provided a “Stock Seller’s Checklist” handout that summarizes the points below. We recommend you read the full write up below and then download the checklist for your future reference.
Click on the image below to download your copy of the “Stock Seller’s Checklist”
1) Does the stock no longer fit my investment strategy / goals?
This is a great reason to sell a stock, and frankly too many investors overlook it.
If you originally bought a stock for a particular reason and the stock no longer fits that strategy, you should consider replacing it with something better.
For example, if you buy a high-dividend stock so you can collect the steady income, and the company slashes its dividend payments due to excess debt, the stock is no longer serving your goals.
Once a stock goes astray, it’s time to consider replacing it with something better.
Which brings us to #2.
2) Is there a clearly better alternative to serve my investment goals?
Investors often become attached to the stocks they’ve researched and bought, but they should always be considering if there’s a better stock for their goals.
Sticking with our example above, if you want high dividend income, constantly be on the lookout for better high-dividend stocks than you currently own.
Over time, things tend to change, stocks become undervalued or overvalued, company performance gets better or worse, and the market presents unique opportunities.
Keep an open mind and an eye on the market for opportunities to upgrade your stocks.
3) Does my original investment thesis now appear wrong?
If you bought a stock based on a theory, and now new information suggests that theory is wrong, you should consider selling the stock for something else.
For example, imagine you invest in low-volatility stocks because you think the economy is going to hit a rough patch.
If it becomes clear that you were wrong about the economic rough patch, then it’s fine to sell your low-volatility stocks and reallocate your money to something better.
Or, perhaps you’ve been investing in fast-growth companies that are riding a strong economic wave. Now, based on your research it becomes clear an economic recession is on the horizon. It would be wise to sell some of your fast-growth positions and reallocate to something more steady and recession resistant.
There’s no need to stick with a strategy once it appears wrong. Constantly consider new information and adapt your investments accordingly.
4) Does financial performance seem to be falling apart?
When a company’s financial performance seems to be coming apart, that can be a good time to sell.
Now, we wouldn’t recommend dumping a good stock just because a company reports mediocre earnings once in a while. That’s a normal part of long-term upward growth.
But if it becomes clear that the business is really struggling, that can be a sign of hard times ahead for the stock. It could be time to sell.
5) Does management appear incapable or incompetent?
If company executives seem erratic, unstable, incompetent, or otherwise unsuited to do the job of leading the company, you might want to look for something better.
Even though companies are made up of hundreds or thousands of employees, executive leadership can have a large impact on a stock.
Not only can executives shape major strategic and operational decisions, but underperforming executives can catch the attention of the media, usually in a bad way.
If the C-suite (CEO, CFO, CIO, etc.) doesn’t seem up to the job, consider selling your stock.
6) Does the stock seem extremely overvalued?
When a stock becomes extremely overvalued, it often has nowhere to go but down.
Now, we wouldn’t recommend selling a stock every time you think it’s trading slightly above its fair value. In fact, it’s not uncommon for the best companies to be fairly valued or slightly overvalued.
But when something is trading at 20%, 30%, 40%, or more above what you think is a fair price, then it could be time to take your profits and wait for it to come back down to earth or consider buying something else instead.
7) Are there signs of serious financial fraud / corruption / criminal activity?
This is an easy one. If you see signs of serious fraud, corruption, or criminal activity, you should run.
Companies that have been breaking the law tend to have long periods of struggle.
Law enforcement investigations take time and often uncover more wrongdoings than originally imagined. All the while, a media feeding frenzy is blasting out the bad news.
There are thousands of stocks available on the market, why choose to own a rotten apple?
8) Has the stock grown to make up too much of my portfolio weight?
This is more about balancing your overall portfolio than judging the company itself.
Sometimes a stock can grow to become a disproportionately large portion of your portfolio.
For example, imagine you buy 10 stocks, each with 10% of your portfolio weight. In other words, if you’re investing $10,000, you put $1,000 into each stock.
Over time, one stock does tremendously well while the others struggle. One day, you look and see your winning stock position has grown to be $3,000 in size while the others have stayed roughly the same size or shrunk.
Now, your total portfolio is worth $12,000.
The problem is that your winning stock is now 25% of your portfolio’s weight!
At $3,000, it controls one quarter of your $12,000 portfolio’s performance.
Keep in mind, owning 10 positions doesn’t provide proper diversity if your money is overly concentrated in just a few of the holdings.
In the situation above, you may want to sell some of your gains from the $3,000 stock and invest the money into your current or new positions.
Now, you don’t need to be constantly rebalancing to make sure every position contributes a perfect portfolio weight. Some fluctuation is normal.
But when a single position makes up 20% or more of your portfolio it’s probably time to rebalance.
9) Do I have an unexpected financial need for the money?
In our last lesson, the first item on our checklist was to ask yourself, “Am I only investing money I won’t need for the next 5-10 years?”
That said, life happens. Sometimes you need to pull money out of the market for unexpected expenses or exciting new opportunities.
If an unexpected financial need comes up, it’s fine to sell some of your stocks.
Just remember to keep your portfolio diversified. For example, you wouldn’t want to sell five of your 10 stocks and be left with all your investment money in just five positions.
Instead, you might trim all your 10 positions to be half their size. That way you preserve your portfolio diversification but still free up half your money.
10) Do I want to take a capital loss to offset a capital gain?
While no investor likes to lose money on his investments, sometimes a large capital loss can be used to avoid taxes by offsetting future capital gains.
As we discussed in our lesson on investment taxes, when you realize a loss on your investment, you’re usually allowed to place that loss against capital gains and avoid paying taxes on that amount.
Many investors will review their portfolio at the end of the year to do “tax loss harvesting”, which involves looking for positions with a large capital loss that are no longer worth holding.
Selling these positions can help avoid taxes and keep your investment profits in your portfolio.
Lesson Summary: When Should You Sell a Stock?
Today we covered a 10-point checklist for selling a stock.
Many of the reasons were related to spotting flaws in your stocks while others were related to managing your portfolio, personal finances, and taxes.
When deciding if you should sell a stock, you should be able to confidently answer, “Yes”, to ANY of these 10 questions:
- Does my original investment thesis now appear wrong?
- Is there a clearly better alternative to serve my investment goals?
- Does the stock no longer fit my investment strategy / goals?
- Does financial performance seem to be falling apart?
- Does management appear incapable or incompetent?
- Does the stock seem extremely overvalued?
- Are there signs of serious financial fraud / corruption / criminal activity?
- Has the stock grown to make up too much of my portfolio weight?
- Do I have an unexpected financial need for the money?
- Do I want to take a capital loss to offset a capital gain?