How to Sell Stocks Profitably
By
Timothy Lutts, Chief Investment Strategist and Editor of
Cabot Stock of the Month Report From Cabot Wealth Advisory 5/7/09
Sign up for free Cabot Wealth Advisory e-newsletterLast week I received the following note from a reader:
"Since I just started investing in early March 2009, and linked up with you folks shortly thereafter, I've been mighty lucky (too early to call my
successes SKILL), and have seen my two portfolios (IRA and separate investment account) grow from $70,000 to $155,000 and from $150,000 to $200,000 respectively.
"My question is about when you normally sell stocks that have done well. Do you sell when a stock's price has advanced X% even it that means you might miss out on continuing upward movement? Instead of percentage increases, do you, instead, sell when the dollar increases have reached a certain level? Do the tax implications of holding onto a stock long enough for capital gains to kick in impact your decision to take a profit? You likely use mathematical formulas, chart analysis and other sophisticated tools and in-depth data that I'm not qualified to use or don't have access to. If that is the case, then I'll have to continue to take a profit from each stock when my "gut" tells me to, but that is a pretty lousy system.
"I have the same questions as above regarding the point at which you sell a stock at a loss.
"My guess is that a lot of your inexperienced, newer subscribers are as perplexed over this issue as I. Therefore, if you want to respond to your general readership and use me as an example, feel free to do so.
"Thanks ahead of time for your reply!"
L.S.
Atlanta, Georgia
Dear L.S.,
First, I don't think you were lucky; I think you were courageous! When you started investing, back in early March, most investors were scared to death of stocks, while the man on the street feared the economy was headed for 10 years of no-growth ... or worse. Now, of course, they all feel a bit better, partly because the market has rallied tremendously since then.
The ability to avoid the curse of group-think is a tremendously valuable trait in the investing business, and if you can maintain that ability, I think you'll do very well with your investments.
So what to do now, with all these paper profits?
In general, you should work to hold your best-performing stocks as long as they continue to perform well, while getting rid of your worst performers, continually upgrading your portfolio so that it is always composed of healthy stocks with good prospects for advancement.
In practice, this means you should watch their charts, and that, of course, is where it can get complicated.
Many technical analysts, including us, watch the 25-day and 50-day moving averages of stocks, asking their stocks to stay above these lines, and selling if they don't.
(Netflix (NFLX) and
Sturm, Ruger (RGR) had been good examples of this in recent months, coming close to their 50-day averages several times, but always recovering. NFLX, though, broke down today.)
A similar method is to ask the stock to simply close each day above its lowest close of the previous week, selling if it doesn't. Both these methods can be implemented by using automatic stop orders placed with your broker.
These systems are fairly simple, but they have their drawbacks, the biggest of which is the whipsaw. A whipsaw happens when a stock rebounds soon after your system has told you to sell it.
You can add complexity, and improve your results somewhat (and avoid some whipsaws), by studying trading volume patterns as well. Growing volume on up days is good, while increasing volume on down days is bad. Gaps up on big volume after an earnings report (we've seen several of these recently) can be very good, predicting further upside, while the converse is true for gaps down. A heavy-volume down day, perhaps two to three times normal volume, can be a great sell signal. (We saw this in late-April with MYGN, when heavy selling foreshadowed the poor earnings report of early May that sparked wholesale dumping.)
On the other hand, if trading volume is below average on a pullback, it can tell you there's no power behind a stock's move. If your stock dips below its moving average on lower than usual volume, you might hold on, and thus avoid being whipsawed.
Another way to avoid whipsaws is to sell on strength. You might do this if a stock gets to be too large a portion of your portfolio, and you want to rebalance to reduce risk. You might do it if you think a stock is "running out of gas," advancing to new highs on decreasing volume. (Look at QSII recently.) And you might do it if you (L.S., with your ability to run contrary to the crowd) believe the broad market has become overbought in the short-term and is due for a correction.
There's a fair chance of that now, with this two-month rally in the rear-view mirror and worries now easing about housing, swine flu, GM's future, unemployment, consumer spending, etc. Trouble is, if you follow all these suggestions about taking profits quickly, you'll have a hard time building really big profits over the long term, and taking advantage of the power of compound growth.
So, for companies with the best investment prospects, I encourage you to take a longer perspective. Maybe sell 10% of your shares if the stock gets extended, but be more patient about holding through corrections, particularly if fundamental growth prospects appear to still be sound and you believe the stock has not yet reached the Point of Peak Perception.
The Point of Peak Perception is the point at which a well-known stock tops out, simply because everyone who wants to own the stock owns it by then, expecting great things for the future. There are no buyers left to buy. Perceptions among investors can only get worse. And as perceptions erode, the sellers take control, driving the stock down as they exit looking for greener pastures.
Microsoft, Intel and Citigroup, for example, are well beyond their Point of Peak Perception while
Brinks Home Security (CFL),
Green Mountain Coffee Roasters (GMCR) and
American Superconductor (AMSC)—all recommended in Cabot advisories recently—are still far from it...meaning the profit potential is greater in these stocks.
As for taking losses, here's an email that arrived this week from a long-time subscriber from Rochester, Minnesota.
"Tim, the first and greatest lesson I have learned from you is when the stock loses ground (pick a number, 8% or 10% or 15-20%), SELL ! SELL ! SELL ! We have an advantage over the Big Boys who are unable to move large volumes of stock. My number is 8% to 10% or when the momentum is adverse. Just SELL and move on. This kept me out of trouble with the bear market last summer but no one escaped unscathed."
What can I add to that? There's no shame in taking a loss; the shame lies in holding a loss and watching it get larger. But you can minimize your loss-takings by buying smart, and by practicing market timing, favoring cash when the market's broad trend is unsupportive, as it was last year.
As for your question about taxes, we don't consider them much, and neither do the majority of our readers. One simple strategy is to use your IRA for investments that might be shorter-term, and your taxable account for investments with a better chance of lasting longer.
Finally, you'll find much more great content on these important topics on our Web site under the
Education.
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