When the dotcom bubble burst in the spring of 2000 and the market started its descent into a bear market, investors froze like deer caught in oncoming headlights. Many didn't even react until the value of their portfolio holdings had declined by as much as 50-60%. (For further reading, see When Fear And Greed Take Over and Basic Investment Objectives.)
There is absolutely no guarantee that a stock will ever come back. In fact, waiting to break even - the point at which profit equals losses - can seriously erode your returns. To demonstrate the importance of cutting losses, the chart below shows the amount a portfolio or security must rise after a drop just to get back to even.
| Percentage Loss | Percent Rise To Breakeven |
| 10% | 11% |
| 15% | 18% |
| 20% | 25% |
| 25% | 33% |
| 30% | 43% |
| 35% | 54% |
| 40% | 67% |
| 45% | 82% |
| 50% | 100% |
A stock that declines 50% must increase 100% to break even! Think about it in dollar terms: a stock that drops 50% from $10 to $5 ($5/$10 = 50%) must rise by $5, or 100% ($5/$5 = 100%), just to return to the original $10 purchase price. Many investors forget about simple mathematics and take in losses that are greater than they realize. They falsely believe that if a stock drops 20%, it will simply have to rise by that same percentage to break even.
This isn't to say that rebounds never happen. Sometimes a stock has been unfairly pummeled (see Forces That Move Stock Prices). But the long turnaround waiting period (about three to five years) also means the stock is tying up money that could be put to work in a different stock with much better potential. Always think in terms of future potential - you can't do anything about the past, so stop clinging to it! (See Ten Tips For The Successful Long-Term Investor.)
The Best Offense Is a Good Defense
Championship teams have one thing in common - a good defense. This principle can be applied to the stock market as well. You can't win unless you have a predetermined defense strategy to prevent excessive losses. We say "predetermined" because either before or at the time of purchase is the time when you can think most clearly about why you would want to sell. You have no emotional attachment before you buy anything, so a rational decision is likely (see The Importance Of A Profit/Loss Plan). Once we own something, we tend to let emotions such as greed or fear get in the way of good judgment.
An Adaptable Selling Strategy
The classic axiom of investing in stocks is to look for quality companies at the right price. Following this principle makes it easy to understand why there are no simple rules for selling and buying - it rarely comes down to something as easy as a change in price. Investors must also consider the characteristics of the company itself. There are also many different types of investors, such as value or growth on the fundamental analysis side.
A selling strategy that's successful for one person might not work for somebody else. Think about a short-term trader who sets a stop-loss order for a decline of 3%; this is a good strategy to reduce any big losses. The stop-loss strategy can be used by longer-term traders also, such as investors with a three- to five-year investment time frame. However, the percentage decline would be much higher, such as 15%, than that used by short-term traders. On the other hand, this stop-loss strategy becomes less and less useful as the investment time frame is extended.
If you're thinking about selling, ask yourself these questions:
1. Why did you buy the stock?
2. What changed?
3. Does that change affect your reasons for investing in the company?
This approach requires you to know something about your investing style. If you bought a stock because your uncle Bob said it would soar, you'll have trouble making the best decision for you. If, however, you've put some thought into your investment, this framework will help. The first question will be an easy one. Did you buy a company because it had a solid balance sheet? Were they developing a new technology that would one day take the market by storm? Whatever the reason was, it leads to the second question. Has the reason you bought the company changed? If a stock has gone down in price, there is usually a reason for it. Does the quality you originally liked in the company still exist, or has the company changed? It is important to not limit your research to only the original purchase reasons. Review all of the latest headlines related to that firm as well as its Securities & Exchange Commission filings for any events which could potentially diminish the reasons behind the investment. If after some research you see the same qualities as before, keep the stock.
If you have determined that there has been a change, then proceed to the third question: is the change material enough that you would not buy the company again? For example, does it alter the company's business model? If so, it is better for you to offload the position in the company, as its business plan has greatly diverged from the reasons behind your original investment. Remember not to get emotionally attached to companies, and making smart sell positions will become easier and easier.
A Value Investor's Approach
Let's demonstrate how a value investor would use this approach. Simply put, value investing is buying high-quality companies at a discount. The strategy requires extensive research into a company's fundamentals. (For further reading, see the chapter on value investing in our tutorial Guide To Stock-Picking Strategies.)
1. Why did you buy the stock?
Let's say our value investor only buys companies with a P/E ratio in the bottom 10% of the equity market, with earnings growth of 10% per year.
2. What changed?
Say the stock declines in price by 20%. Most investors would wince at seeing this much of their hard-earned dough evaporate into thin air. The value investor, however, doesn't sell simply because of a drop in price, but because of a fundamental change in the characteristics that made the stock attractive. The value investor knows that it takes research to determine if a low P/E and high earnings still exist.
3. Does that change affect your reasons for investing in the company?
After investigating how/if the company has changed, our value investor will find that the company is experiencing one of two possible situations: it either still has a low P/E and high earnings growth, or it no longer meets these criteria. If the company still meets the value investing criteria, the investor will hang on. In fact, s/he might actually purchase more stock because it is selling at such a discount.
With any other situation, such as high P/E and low earnings growth, the investor is likely to sell the stock, hopefully minimizing losses.
There's No Rule That Fits All
This approach can be applied by any investing style. A growth investor, for example, would simply have different criteria in evaluating the stock. Notice we've referred to this approach as a guideline. It requires thinking and work on your part to ensure these guidelines maximize the effectiveness of your investing style. All investors are different, so there is no hard-and-fast selling rule which all investors should follow. Even with these differences, it is vital that all investors have some sort of exit strategy. This will greatly improve the odds that the investor will not end up holding worthless share certificates at the end of the day.
The point here is to think critically about selling. Know what your investing style is and then use that strategy to stay disciplined, keeping your emotions out of the market.
