Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com
These days, the No. 1 question for many investors (both those in the market and those on the sidelines) is whether the recent market drop is the beginning of the correction we've been waiting for.
The fixation on immediate market moves is consistent with what I've heard in more than 20 years of interviewing individual investors as part of my consulting work for financial institutions.
A common complaint during those conversations: "My adviser is reasonably good about telling me when to buy a stock, but terrible about telling me when to sell it."
There's a good reason for this. Given the long-term upward trajectory of stocks historically, recommending that investors buy had a high likelihood of being good advice over time. In addition, selling a stock that has gone up in value can result in taxes that many investors resist paying.
Here are five common strategies to decide when to sell a stock. Many revolve around risk management - trading off potential upside for downside protection. And remember that you need to take taxes into account in selling.
I should stress that describing these selling strategies doesn't mean I endorse them - in fact, few topics inspire more disagreement among financial advisers and money managers.
Watch for cockroaches
One approach is to sell a stock at the first announcement of bad news or disappointing earnings. Even though the bad new is immediately reflected in the share price, some seasoned money managers are believers in the "cockroach theory" when it comes to negative announcements: "Once you see one, it's almost certain that others will follow."
In the case of stocks such as Nortel in 2001 or banks in early 2008, this would have been a winning strategy for anyone who sold on the first, second or even third negative announcement. This approach is especially common among growth stocks, with elevated valuations dependent on strong future growth in sales and profits - where even a small downward adjustment in growth forecasts means a stock's price can get crushed.
Use the house money
Another strategy is employed by some risk-averse investors when an initial investment has doubled in value. At that point, they sell half their holding, so they have now their original investment back, and deploy it elsewhere. Meanwhile, they let the balance of their investment run. In casino terms, because they no longer have any of their initial stake invested, they're playing with the house's money. The downside, of course, is that they've reduced their upside by half.
Set target prices
Some money managers employ the disciplined use of target prices to help identify when to sell holdings. Whenever they buy a stock, they set a target price that in their view reflects its intrinsic value. So if a manager thinks a stock is undervalued by 40 per cent and buys it at $24, the target price might be $40.
Selling a stock that has done well can be difficult. That's the reason for having preset trigger points, so that when the stock hits $40, barring significant new information, the premise is to sell at least part of the holding. As the old investing axiom goes: "You'll never go broke taking a profit."
Some investors also set downside target prices: If a stock drops below a predetermined threshold, they cut their losses and sell it. One way to automate that process is via a stop-loss order, where shares are sold the moment they drop below a specified level.
Establish thresholds
Over the past year, we have all been reminded of the inherent risk in stocks. That risk is increased when individual companies and sectors do particularly well and, as a result, their weighting increases in the market generally and our portfolio in particular. (Of course, the same thing can happen when some stocks stay the same while the rest drop.)
Selling disciplines can be put into place to help control risk. One simple strategy is to set a maximum percentage of your portfolio that no single investment will ever exceed, such as 5 per cent.
Compare relative value
A final common selling strategy relies on relative value. This entails measuring valuations of the stocks you hold compared with ones you don't, whether in the same sector or different industries. Some managers model a company's future cash flows to create a "present value" of expected cash, and compare that present value with other stocks; others focus on deconstructing a company's balance sheet.
Just as there are numerous strategies for buying stocks, so there are a variety of approaches to knowing when to sell. What the approaches described here have in common is that they require discipline. The key to the success of any approach to selling - as with investing in general - is to select the approach that works for you and then to stick to it.