Let’s take a look at the reasons and situations in which an investor should sell.
1. Better opportunities:
Sometimes, there’s absolutely nothing wrong with a company or its stock. There are simply better investment opportunities elsewhere that would yield higher returns. Investors can then consider selling a less attractive stock (even at a loss!) if they believe they can get better returns by investing elsewhere.
2. Change in business:
Businesses change, sometimes significantly. This could be in terms of a major acquisition, a lasting modification in the industry’s fortunes, change in management or its style of working, the fading of its moat, or a shift in the competitive landscape.
When this occurs, investors should ideally incorporate the new information and re-evaluate the situation to see if the reasons for which they purchased the company’s shares are still relevant. If the company no longer provides ‘excellent economics’, or is no longer run by an ‘able and honest management’ amounting to the investors’ original investment thesis not holding good in the changed scenario, they may consider selling the stock, regardless of its price at that point in time.
The key question for investors to ask is if a business is delivering what they envisaged it would. In other words, is the business’ performance as a whole in line with their long-term projections? Though some slippages or a minor misallocation of capital could be tolerated, the same cannot be said about large proportions.
Holding on to these stocks only dilutes the quality of the investors’ portfolios and their long-term performance. So, if this strategy is not workable in terms of the value proposition going forward, then it could be time to assess losses made by selling the stock, and switching to those offering superior investment opportunities.
One tends to invest for the long term in India. However, one should consider selling if the stock price escalates to a point where it no longer reflects the underlying value of the business. Additionally, one should re-examine his/her evaluation of a company’s fundamentals when the stock suffers an unusual decline in its price. When bubble bursts, stock prices will not rise to the previous level until the fundamentals improve again. There will be no immediate rebound, as the drop is a correction of the previous mispricing.
Warren Buffett advocates selling a stock early when an investor has bought a ‘cigar butt’ — a mediocre company that has the capacity to give one last puff of pleasure before it sinks into oblivion. Though Mr Buffett’s preferred holding period is forever, his theory can only be applied to a handful of really great businesses.
The primary argument against selling is that the stock price always goes up over the long term, and thus will recover, or be worth more in the future. Though this generally holds true, there are two important caveats to this deduction.
The Nikkei index peaked in 1989 at 38,915 during the height of the Japanese economic bubble. Even at its 2018 high, it is 37 per cent short of that peak. Further, there is absolutely no guarantee that stock price of any one company will recover from a drop. Hence, there are times when admitting a mistake and selling the share would be called for.
Opportunity cost is the value an investor could get from making an alternative investment. Investing money in a stock that is in the doldrums implies that it is not deployed in an alternate avenue or financial instrument that could prove to be more profitable, and with greater scope for growth going forward.
4. Faulty investment thesis
Investors should seriously consider selling a stock if it so happens that their rationale for buying it was flawed, if the valuation was too optimistic, or if there are any additional risks associated with it.
5. It keeps the investor up all night
If an investment’s price has plunged in a way that it causes investors to lose sleep over it, it is a signal for them to move their money elsewhere.
How to protect portfolios from downside risk:
Diversification: Investors can reduce their downside exposure by making sure that their investment is diversified across individual stocks and sectors. This is particularly important for those with insufficient time to conduct research or go into the details of industries and individual stocks. During a recession, however, this theory may not hold true. This is where diversification among negatively-correlated asset classes can be of some help.
It is wise for investors to ascertain the maximum percentage of their portfolio that should be invested in a single stock. Even if they spread their bets evenly across a number of stocks, a single company’s stock can perform so well that it becomes an enormous allocation. This could also be a cause for worry.
At the end of the day, however, it’s up to investors to weigh and acknowledge the risks and rewards that come with the allocation of stocks in their portfolios.
Negatively correlated assets: An asset with negative correlation with respect to stocks simply means that when the price of the said stock falls, that of the concerned asset rises. By investing in negatively-correlated assets, investors are effectively hedging them.
However, in the case of a black swan event like the Lehman Brothers’ crisis in 2008, even the prices of negatively-correlated assets can plunge together.
You, far more than the market or the economy, are the most important factor in your long-term investment success. – Burton Malkiel
In addition, there is a phenomenon called the behaviour gap. This implies that individual investors could buy and/or sell at the wrong time, thus damaging their long-term returns. It is not only regular investors for which this holds true. Professional investors can also make investments that underperform the market as a whole, year after year.
I would like to conclude by saying that though the last stages of a bull market can often be very lucrative, it is always better to invest for the long term.