Getting Out While the Getting's Good
By WALTER HAMILTON
September 18, 1998
When should you sell a stock? If you're bargain hunting in today's dicey market, the answer is sooner rather than later--that is, if the stock moves against you.
The market's summer plunge has made for some good buying opportunities. But it has also made for a risky investment climate in which it's easy to lose money quickly, experts note.
To protect against that, some investment pros say individual investors should take the bold step of jettisoning any stock that falls as little as 8% from the price at which they bought it.The reasoning: For most of the 1990s' bull market, stocks often bounced back quickly from trouble as a rising tide lifted most boats.
But today, a stock that begins to sink may quickly crash--and stay down.
"The very best investors I know have very set parameters for losses," said Jonathan Lee, managing partner at Hollister Asset Management, a money management firm in Century City. "They say: 'I'm going to buy and have very tight risk parameters. If it goes down 5%, I'm out.' "
Dumping a stock that drops 8% or so from your entry price may sound drastic. Even in a good market, prices naturally ebb and flow, and an investor who sells after a small loss could subsequently watch the stock rebound.
Indeed, conventional wisdom is that an investor needn't reexamine a stock unless it declines 15% or more. If a stock has fallen simply because of market sentiment--rather than because of a fundamental change in the company's prospects--traditional thinking says an investor should hold on.
But in a high-risk market like this one, one or two sizable losses can crush a portfolio.
Think about this: If an investor waits to sell a falling stock until the loss is 20%, and then reinvests the proceeds in another stock, that new holding must rise 25% just to recoup the original amount. After a loss of 30%, a fresh holding must climb 43% to get the investor back to even.
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Some pros take a more basic view of why losers should quickly be sold.
"The best reason why you should not hold [a losing] stock is . . . you've made a mistake," said David Ryan, head of Ryan Capital Management, a Santa Monica-based hedge fund.
Ryan is a onetime protege of William O'Neil, an investment legend and founder of Investor's Business Daily newspaper. O'Neil has long been one of the more vocal proponents of the
"8%-loss-and-out" sell rule.
Note that this rule applies only to newly purchased stocks--not to price moves in shares that an investor has owned for a while and that have appreciated in value.
In those cases, assuming you're holding the stock as a long-term investment, interim moves that may erase some of your gain (without reducing your original principal) are OK to ride out, so long as they reflect overall market weakness rather than problems specific to the company.
The conventional thinking about sticking with a stock that falls sharply from your purchase level also misses another point:
A stock often turns down before an erosion in the company's fundamentals is readily apparent.
Even the most diligent investors have trouble getting access to the best information. They may not know exactly why a stock is going down, but they can often infer from the action in the shares that the company's outlook is dimming.
"Many times a stock will tell you something bad about the company before anyone else will," said Tom Barry, investment chief at George D. Bjurman & Associates in Century City, which manages $1 billion.
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But what about the practical issues involved in quickly selling stocks that move against you? True, there are commission costs. And depending on market conditions, an investor may end up taking a large number of losses.
Still, better to take smaller losses than risk that they become major losses, many pros say.
Investment legend Peter Lynch has long noted that investors are likely to make the bulk of their profits in a relative handful of stocks that rise dramatically over time. Most stocks in a portfolio, Lynch has said, will be mediocre or poor performers. Thus, keeping losses to a minimum assures that your few big gainers aren't watered down by big losers.
Indeed, many pros insist that small investors' prime mistake usually is to hold losers too long, hoping to at least break even.
"There are too many companies where things are going great. Why not switch?" Barry said.
"There are so many people who don't want to admit a loss, so they hold their losers. We do the opposite. We sell the losers and keep the winners."
Psychologically, the 8%-loss sell rule may be easiest to observe in the case of higher-priced stocks. An 8% drop in a $50 stock is $4, while for a $25 stock it's only $2.
Still,
investors should remember to focus on the percentage loss, not the dollar amount.
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To see the benefit of the 8% sell rule in action, imagine you bought Chase Manhattan at its July 31 peak of $77.56. Let's say you disregarded the sell rule, which would have gotten you out a mere two days later at about $71, as the stock slumped.
You might have figured that Chase, as a blue-chip stock, would be insulated from a sharp drop.
But amid deepening worries about U.S. banks' potential trading and loan losses overseas, Chase shares have plunged to $47.88 now--a drop of 38% from the peak.
It's entirely possible that the fears are overdone and that Chase will emerge unscathed from the current global turmoil.
But it remains to be seen whether an investor who has ridden the stock down will be able to claim the same thing.
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Times staff writer Walter Hamilton can be reached by e-mail at
walter.hamilton@latimes.com.
http://articles.latimes.com/1998/sep/18/business/fi-23902
