A reader asks:
I have some stocks that have seen big gains since April. I’m curious if you have a rule of thumb for selling stocks that are making big gains in a short period of time. I keep most of my portfolio in index funds, but I like to buy some individual stocks that I feel strongly about. I like to hold most of them for a longer period of time, but for some that are more volatile, I tend to trade more short-term and put the gains into my index fund holdings. I know there are tax implications here, but ultimately I know I won’t be upset if I make a double-digit profit in a month or two.
Another reader asks:
Given the recent run-up, I’m noticing that several of my five individual stock positions have grown past the <5% concentration level. In both cases, I sold enough shares to get back to just under 5%, but I'm starting to feel a little sorry for leaving extra profit on the table. Does the 5% rule make sense? Or does it not matter much if the individual stocks are not part of my core investments?
There are countless books about buying stocks.
I’ve never come across a useful book that tells you when to sell.
One of my favorite scenes in Some good men is when they put a young Noah Wylie on the stand to be interrogated by Tom Cruise and Kevin Bacon:
A Code Red or directions to the dining room are not in the handbook. Not even when the sale of a share has to be perfectly timed.
Understanding when to sell a stock is not a science.
A small number of stocks are responsible for the vast majority of stock market gains. Many stocks falter and never reach their previous highs. While picking stocks is difficult, there are clear examples where owning individual names has paid off: Nvidia, Amazon, Apple, Microsoft, to name a few.
This is one of the reasons why buy & hold is an easy strategy in name only. It’s really hard to buy and hold because quick wins and quick losses can make you question even your strongest investment views. Things are even amplified if you own individual stocks.
The idea of placing position size limits on your portfolio makes sense because it forces you to rebalance when the position gets too high or too low.
But some people might quibble with this strategy. Peter Lynch says, “Selling your winners and holding on to your losers is like cutting off the flowers and watering the weeds.”
This makes sense to me. Rebalancing asset classes or investment strategies makes much more sense than doing so with stock selection.
The point is that you do need some sales discipline, otherwise you will invest like a rudderless ship.
There are many different ways you can could sell your shares.
Some people make short-term trades. Some are looking for consistent dividends. Some look at technical or momentum indicators. Some invest purely based on valuations. Some people plan to buy and hold.
In general, you don’t want an investment to turn into a trade unless the short-term gains are so great that you struggle.
This is the most important question to ask when thinking about when it’s time to sell a stock:
Why did you buy the shares in the first place?
Is it a transaction or an investment?
Do you have a price or return target in mind?
What would make you change your mind about the stock?
What is your time horizon?
Do you shortchange your losers or lean into the pain and buy more when stocks are on sale?
You could set stop losses but individual stocks are volatile, so you may be held back by a stock you want to hold for the long term.
You can sell if a share becomes too expensive but valuations are often unreliable as timing indicators.
You can sell if your thesis has been changed but that requires coming up with a legitimate fundamental thesis to begin with.
The truth is, knowing when to sell a stock is more art than science.
Therefore, it is difficult to beat the market.
No one ever went bankrupt by making a profit, but no one ever got rich by selling early either.
Most importantly, you need to define what you’re looking for in a stock before you buy it, not after.
It’s impossible to know when to sell a stock if you don’t have a plan before you buy it.
Josh Brown joined me this week on Ask the Compound to discuss these questions:
We also answered questions about what to do with an inheritance, how to invest in middle age and some career advice for a young advisor.
Further reading:
The best time to sell your shares
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