- One reason is the difficulty of knowing precisely what an investment is worth.
- An investor buys with a range of value in mind at a price that provides a considerable margin of safety.
- As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases.
- Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.
To deal with the difficulty of knowing when to sell, some investors create rules for selling based on
- specific price-to-book value or price-to-earnings multiples.
- Others have rules based on percentage gain thresholds; once they have made X percent, they sell.
- Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell.
Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell or buy depends on the alternative opportunities that are available.
Should you hold for partial or complete value realization, for example?
- It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.
- By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available.
Some investors place stop-loss orders to sell securities at specific prices, usually marginally below their cost.
- If prices rise, the orders are not executed.
- If the prices decline a bit, presumably on the way to a steeper fall, the stop-loss orders are executed.
Liquidity considerations are also important in the decision to sell.
- For many securities the depth of the market as well as the quoted price is an important consideration.
- You cannot sell, after all, in the absence of a willing buyer, the likely presence of a buyer must therefore be a factor in the decision to sell.
- As the president of a small firm specializing in trading illiquid over the counter stocks once told me: "You have to feed the birdies when they are hungry."
If selling still seems difficult for investors who follow a value-investment philosophy, I offer the following rhetorical questions:
- If you haven't bought based upon underlying value, how do you decide when to sell?
- If you are speculating in securities trading above underlying value, when do you take a profit or cut losses?
- Do you have any guide other than "how they are acting," which is really no guide at all?