The Investment U E-Letter: Issue # 136
Thursday, May 9, 2002 When To Sell Stock: The Only 2 Reasons To Unload an Investment
by Dr. Steve Sjuggerud, Chairman, Investment U
Argh! I get so frustrated!
We now know that you can't trust the brokerage firms to tell us when to sell stock. Their analysts were putting out "Strong Buy" recommendations on internet stocks to the public, while behind closed doors they were calling those stocks "pieces of s**t… " You can't trust "Money Magazine" to tell us when to sell stock--as its advice is always "never sell: just keep buying and holding and dollar-cost-averaging." Meanwhile, your portfolio falls in half. You can't trust your financial planner or broker for advice on when to sell stock, because he's afraid that if you sell, he won't earn a commission on your cash-or worse, you'll take your money away from him. It's frustrating. But what REALLY frustrated me was a recent article on when to sell from Morningstar, one of the few sources of independent information. I'll get to that in a moment, but first… When To Sell Stock: The Only 2 Reasons To Unload an Investment Look, there are only TWO reasons to sell stock or another investment: 1. If the reason you invested is no longer there.
2. Or, if you've hit your pre-defined "point of maximum pain" - your trailing stop. That's it! That's all you need to know. So if you bought GE because of Jack Welch, why do you still own it? If you bought a biotech stock because a drug was going to pass, and it failed, why do you still own it? If you bought because a stock was super-cheap, and it's now super-expensive, why do you still own it? If the reason you bought the stock is no longer there, that's when you sell the stock. It's that simple. The "Killer" Catastrophic Loss Failing that, if you hit your point of maximum pain, that's when to sell your stock. The biggest killer to a portfolio is a "catastrophic loss." If a stock falls 90%, it has to rise by 900% to get you back to where you were. That's not going to happen. So you can never allow yourself a catastrophic loss. The best rule of thumb I've found is to use a 25% trailing stop. That way, you never have a catastrophic loss. Those are the only two things you need to know about when to sell stock. The rest of the stuff out there is convoluted, confusing advice that you couldn't possibly follow. To show you what I mean, here are some "tips" from that recent Morningstar article I mentioned earlier… Bad "When To Sell" Advice From Morningstar "[Yahoo] Lesson: It doesn't matter whether you were right or wrong in the past. Make your decision based on your estimate of the future, and act accordingly." This investment advice is terrible. How can you make an estimate on the future? The future is unknowable. Basing your actions on the unknowable is a recipe for disaster. "[First Data] Lesson: Know your investments inside and out, and you'll be better able to decide whether a share-price decline is a sell signal worth listening to, or a buying opportunity." Terrible advice again. How can you really know your investments "inside and out" as they suggest? Nobody can really know-Arthur Andersen didn't know. Because you can't possibly "know your investments inside and out," you should never…I repeat NEVER…buy more or "average down" on a decline. "[Tellabs] Lesson: If you're buying a stock in an industry that's going through some tough times, start out with a small position - and make sure that whichever company you buy has the balance-sheet strength to weather the toughest times you can imagine." Horrible investment advice yet again. If we've learned anything over the last year, it's that no one can be sure of anything on the balance sheet. How can you ask an individual investor to analyze it to make a great decision about a declining stock in a declining industry? "[Tyco and Qwest] Lesson: No matter how many negative stories "The Wall Street Journal" publishes, no matter how bad "sentiment" gets surrounding a stock, the shares are still worth the present value of its future cash flows. If a stock is trading at a substantial discount to that value - and when the future is uncertain, you definitely want a big discount - it's a better time to be buying than selling." This advice is the equivalent of recommending holding a ticking time bomb instead of getting rid of it. The truth is, nobody knows the present value of the future cash flows of Tyco or Qwest. And chance are, you'll be the last to know. This is where having a point of maximum pain becomes essential-you'll be out before the crash comes if it does. My apologies for giving Morningstar a hard time here. I really do think they put out excellent products for individual investors. I think that most of the stuff out there is so bad it's not even worth dignifying with a review. But as one of the few independent analysts out there putting out a decent product to individual investors, I thought they'd do better than this. Folks, you can't know the future. I can't know the future. But we can define our rules for knowing when to sell stock in order to protect our wealth. The rules for selling are simple. Ignore all that "know the balance sheet" and "know the present value of the future cash flows" garbage. You can't know it. Not even the experts know it. The smartest thing you can do is admit you don't know it, and follow the only two reasons to sell stock you'll ever need: - When the reason you invested is no longer present, or
- When your point of maximum pain has been hit.
You'll be infinitely wealthier, and it takes a lot less work! Today's IU Crib Sheet - There is no shortage of advice available to you today on when to sell stock and other investments. But most of it-from brokerage firms, your financial planner or the mainstream media-cannot be trusted. Always remember to consider the source of the advice…as well as what his or her motive might be.
- Some of the "advice" you will see about when to sell stock may appear to make sense to novice investors…but at this point we should all know better. Take a moment to re-read some of the Morningstar "tips" listed above and ask yourself if you might have believed them just a few months ago. (Remember - there are only TWO reasons to sell stock…)
Good investing, Steve P.S. Below are some additional Investment U issues related to the topic of 'When To Sell Stock." Enjoy. Return to Archive | 
