▶ Full Post Text
**Excerpt from "The Little Book That Builds Wealth" by Pat Dorsey**
[**https://www.reddit.com/user/raytoei/comments/1hffwex/excerpt\_when\_to\_sell/**](https://www.reddit.com/user/raytoei/comments/1hffwex/excerpt_when_to_sell/)
**Chapter Fourteen: When to sell**
Smart Selling Means Better Returns.
WAY BACK IN THE MID-1990s, I came across a small company called EMC Corporation that sold computer storage equipment. I did some research on the stock, and I decided that although it was a bit pricey at about 20 times earnings, strong demand for data storage, combined with the EMC's solid market position, meant that it should grow at a pretty rapid clip. So I bought a pretty good-sized position for my piddling portfolio.
I then watched the stock go from $5 to $100 in three years—and right back to $5 a year later. I sold about a third of my position at a pretty high price, but I watched the majority come right back down again. I had made a great purchase decision, but my overall return on the investment would have been far, far better had I been smarter about selling.
Ask any professional investor what he or she thinks is the hardest part of investing, and most will tell you that knowing when to sell ranks up there near the top—if not right at the top. In this chapter, I want to give you a road map for selling well, because selling a stock at the right time, and for the right reasons, is just as important to your investment returns as buying a stock with a lot of upside potential.
**Sell for the Right Reasons**
Ask yourself these questions the next time you think about selling, and if you can't answer yes to one or more, don't sell.
\* Did I make a mistake?
\* Has the company changed for the worse?
\* Is there a better place for my money?
\* Has the stock become too large a portion of my portfolio?
Perhaps the most painful reason to sell is that you were simply wrong. But if you missed something significant when you first analyzed the company-whatever it was-then your original investment thesis may very well not hold water. Maybe you thought management would be able to turn around or sell a money-losing division, but instead the company decided to plow more money into that segment.
Perhaps you thought the company had a strong competitive advantage, but then the competition started eating its lunch; or maybe you overestimated the success of a new product. No matter what the mistake was, it's rarely worth hanging on to a stock that you bought for a reason that is no longer valid. Cut your losses and move on.
I did just this many years ago with a company that manufactured commercial movie projectors. The company had strong market share and a good track record, and multiscreen theaters were springing up like weeds across the country.
Unfortunately, my growth expectations turned out to be way too high, because the multiplex-building boom was waning. Theater owners started to get into financial trouble, and they were a lot more worried about paying their bills-especially the interest on their debt-than they were in building new theaters. I was down quite a bit on the investment by the time I figured this out, but I sold anyway. Good thing I did, too, because the shares subsequently plunged to penny-stock territory.
I should note that this is far easier said than done, because we tend to anchor on the price at which we bought a stock, and we hate losing money. (In fact, numerous psychological studies have proved that people experience almost twice as much pain when they lose money than they experience pleasure when they gain the exact same amount.) This behavior causes us to focus on irrelevant information-the price at which we purchased a stock, which has zero effect on the company's future prospects-instead of much more relevant information, such as the fact that our original assessment of the company's future may have been flat-out wrong.
One trick you can use to avoid anchoring is this: Each time you buy a stock, write down why you bought it and roughly what you expect to happen with the company's financial results. I'm not talking about quarterly earnings forecasts, just rough expectations: Do you expect sales growth to be steady or to accelerate? Do you expect profit margins to go up or down? Then, if the company takes a turn for the worse, pull out your piece of paper and see whether your reasons for buying the stock still make sense. If they do, hold on or buy more. But if they don't, selling is likely your best option-regardless of whether you've made or lost money on the shares.
The second reason to sell is if a company's fundamentals deteriorate substantially and don't look like they're going to rebound. For a long-term investor, this is likely to be one of the more common reasons to sell: Even the best companies can hit a wall after years of success. You may very well have been 100 percent right in your initial assessment of the company's prospects, its valuation, and its competitive advantages, and you may have had a lot of success owning the stock-but as economist John Maynard Keynes once said, "When the facts change, I change my mind."
Here's a recent example from a company I once covered for Morningstar: Getty Images. This is a fascinating company that capitalized on photography's digital migration by building a massive database of digital images that it distributes to ad agencies and other large image con-sumers. Getty essentially became the industry's largest marketplace for images, making it easy for photographers to upload images to its database, and for image users to find exactly the image they need. For a time it was a great business, with strong growth rates, high returns on capi-tal, and massive operating leverage.
So what happened? Essentially, the same digital technology that built the company made it less relevant. As high-quality digital imaging became more accessible to a wider range of users, it became easier to create professional-quality images with cheaper cameras. This led to the rise of web sites selling images that were admittedly lower-quality than the average Getty image, but that were much cheaper (a few dollars versus a few hundred dollars), and good enough for less demanding users. Couple this with the fact that online images don't need to be of as high quality as ones used in print media, and Getty's economics and growth prospects changed markedly for the worse.
The third reason to sell is that you come across a better place for your money. As an investor with limited capital, you want to always be sure that your investments have the highest possible expected return. So, selling a modestly undervalued stock to fund the purchase of a ridiculously mouth-watering opportunity is perfectly logical-and a darned good idea. Of course, taxes come into play here, and you may need a larger difference in potential upside to justify a sale in a taxable account than in a tax-qualified one, but it is nonetheless something to keep in mind. I wouldn't recommend constant portfolio tweaking to move from stocks with 20 percent upside to stocks with 30 percent upside, but when a great opportunity comes along, sometimes you need to sell an existing stock to fund the idea.
For example, when the market sold off during the credit crunch in late summer of 2007, financial services stocks were absolutely crushed. Some were deservedly so, but as is usually the case, Wall Street threw a lot of babies out with the bathwater, and many stocks were whacked down to ridiculously cheap levels. Now, I normally keep at least 5 to 10 percent of my personal account in cash so that I have dry powder for occasions just like this one-you never know when the market will lose its mind-but for a number of reasons, I was caught with very little spare cash during this particular sell-off. So, I started comparing the potential upside from my existing positions with some of the financial stocks that Wall Street was putting on sale.
The net result was that I sold a position that I hadn't owned for very long, but which had only modest upside potential, to fund the purchase of a bank trading at below book value, which had already agreed to be taken over at a higher price--a very worthwhile trade-off.
Remember that sometimes the better place for your money may very well be cash. If a stock has far surpassed what you think it is worth and your expected return from now on is actually negative, then selling it makes sense even if you don't have any other good investment ideas at the time. After all, even the modest return that cash delivers is better than a negative return-which is exactly what you'll get if you own a stock that has run beyond even the most optimistic assessment of its value.
The final reason to sell is the best one of all. If you've had a screaming success with an investment and its market value has grown to make up a big chunk of your port-folio, it may make sense to dial down the risk and shrink the position. This is a very personal decision, as some people are very comfortable with concentrated portfolios (at one point in early 2007, half my personal portfolio was in just two stocks), but many investors are more comfortable limiting individual positions to 5 percent or so of their portfolios. It's your call, but if you get the willies having 10 percent of your portfolio in a single stock, even if it still looks undervalued, listen to your stomach and trim the position. You have to live with your own portfo-lio, after all, and if keeping position sizes down makes you more comfortable, so be it.
Before closing this chapter, I want to quickly draw your attention to the fact that none of the four reasons to sell that I've laid out is based on what happens to stock prices. They're all centered on what happens, or is likely to happen, to the values of the companies whose stock you own. Selling just because a stock price has dropped makes absolutely no sense whatsoever, unless the value of the business has declined as well. Conversely, selling just because a stock has skyrocketed makes no sense, unless the value of the business has not increased in tandem.
It's very tempting to use the past performance of the stocks in your portfolio to decide when to sell. Remember, though, that what matters is how you expect a business to perform in the future, not how its share price has performed in the past. There's no reason why stocks that are up a lot should drop, just as there's no reason why stocks that have cratered have to come back eventually. If you own a stock that is down 20 percent and the business has gotten worse and isn't getting better, you might as well book the loss and take the tax break. The trick is to always stay focused on the future performance of the business, not the past performance of the shares.
**The Bottom Line**
1. If you have made a mistake analyzing the company, and your original reason for buying is no longer valid, selling is likely to be your best option.
2. It would be great if solid companies never changed, but that's rarely the case. If the fundamentals of a company change permanently not temporarily for the worse, you may want to sell.
3. The best investors are always looking for the best places for their money. Selling a modestly undervalued stock to fund the purchase of a supercheap stock is a smart strategy. So is selling an overvalued stock and parking the proceeds in cash if there aren't any attractively priced stocks at the time.
4. Selling a stock when it becomes a huge part of your portfolio can make sense, depending on your risk tolerance.
**FIN**
***(Depending on the response, I will repost part 2 from the other book, also on when to sell)***