Selling is arguably the most difficult aspect of investing in individual stocks. Many of us spend a good amount of time researching possible stock investments before pulling the trigger. Often, however, very little thought is put into when it is time to sell. Do you sell if the price appreciates by a certain amount? Do you sell if the price falls by a certain amount? How far do fundamental factors–and which ones–have to deteriorate?
Depending on the reasons for buying a stock, the reasons for selling may be somewhat diverse. Some investors have very rigid rules when it comes to cutting losses. William O’Neil, founder of Investor’s Business Daily and creator of the CAN SLIM fundamental and technical stock selection methodology, uses a 7% loss rule: “I make it a rule to never lose more than 7 percent on any stock I buy. If a stock drops 7 percent below my purchase price, I will automatically sell it at the market – no second-guessing, no hesitation.”
Dr. James Cloonan, founder of AAII and the creator of the AAII Model Shadow Stock Portfolio, uses a variety of fundamental factors when deciding whether to part company with the micro-cap value companies the portfolio tracks. For example, stocks are sold from the portfolio once their price-to-book-value ratio (P/B) or market cap have risen to more than three times the cap that is used for initial consideration. That means that, currently, stocks in the portfolio are sold if their P/B rises above 3.0 or if their market cap goes above $1.2 billion. In addition, if a company’s trailing 12-month adjusted earnings go negative for two consecutive quarters without there being positive quarterly earnings, a stock is sold from the portfolio.
Weekly Poll Question:
Many investors, though, seem to obsess over price when it comes to selling. To delve into this further, we posed the following question to our readers:
If you lose money in a stock, at what point to you intend to sell?
Here is how they responded:
In all, 1,366 readers participated in this survey. Of those, 58% said they view a drop in stock price as a buying opportunity, assuming the fundamentals of the company haven’t changed. So instead of unloading shares when the price falls, the majority of respondents would scoop up more.
In second place, 23% of readers said they don’t have a fixed sell point, which may indicate their sell rules are more subjective. The problem with not having a defined sell strategy, however, is that it leads some investors to sell quickly after a small price gain or to hold on to big losers in the hopes that the price will eventually rebound.
Another 9% said they would not sell based on a decline in price but, instead, would follow their original plan for when to sell. This seems to indicate that this segment of respondents does not sell based on price, but instead is perhaps following fundamental factors when determining when to sell.
Only 10% of respondents say that sell if a stock’s price falls by some fixed amount. Of those, 79% put 20% as the percentage loss that would trigger a sell.
Risk plays a major role in investing. There is the age-old “risk versus reward” tradeoff, whereby investors should be compensated–through price appreciation and income–for assuming the risk of an investment falling in value. There is a mountain of academic research on the subject of investment risk, and multiple Nobel prizes have been awarded for that research. However, there isn’t a one-size-fits-all definition of risk. Instead, especially for individual investors, the definition of risk and risk tolerance is incredibly personal.
TO get an understanding of how individual investors define risk tolerance, we asked them to define it. Specifically, last week’a special question asked:
How do you define risk tolerance?
In all, we received 78 varied responses.
There were, however, some patterns to the responses. Roughly 14% provided definitions along the lines of the “sleep test”–risk tolerance is the ability to sleep at night with the investments you have in your portfolio. Nearly 17% said risk tolerance is tied to how much loss an investor can accept and the same number defined risk tolerance at the ability to weather to ups and downs in the market.
Here is a sampling of the results:
- “Ability to react to change in a logical manner with preplanned thought.”
- “Being able to sleep through a storm knowing the sun will come out tomorrow.”
- “How much of a decline in a stock or portfolio must occur before action is taken.”
- “I define risk tolerance as that breaking point in a bear market at which one starts to sell their declining assets, expressed as percentage loss. (i.e., sells at 20% loss, 30% loss, etc.) I find one’s risk tolerance is greatly expanded by having a multi-year supply of cash on hand.”
- “I do not have a definition. If I have invested in a stock that appears to not have the fundamentals I believed then this is a serious risk. And, after a while, I may no longer be able to tolerate the risk. Sometimes I realize I have made a mistake. Then I will let a little time pass before I make a decision about selling. If I see a way out without losing too much money I may take it. Or, I might feel I can still profit from the trade.”
- “Risk Tolerance is the ability to ignore ups and downs when the whole market is moving as opposed to a stock specific large move.”
- “When you find yourself thinking about problems with your investments while engaged in a completely different activity, then you’ve met your risk tolerance.”
Everybody has an opinion! Why not give us yours? Participate in our weekly member poll, updated every Monday, and see the results online at http://www.aaii.com/memberquestion.