Even ‘buy and hold forever’ investors like Warren Buffett sell holdings from time to time, perhaps even more often than his reputation suggests. Why sell an investment? There are good reasons, and not so good reasons, why investors sell. Here are some of the major ones:
Good Reasons to Sell
A security has reached what you think is full valuation. All assets have an historical valuation range of based on various metrics – P/E ratios, multiple of sales, cap rates, etc. Sometimes assets are cheap, sometimes they are expensive. While bubbles, let alone strong markets, can go on longer than people think they ‘should’ (just ask Allen Greenspan who predicted an end to the internet mania driven stock market bubble…3 ½ years early, in 1996), there is no shame in selling a stock when it has reached the high end of its historical valuation range. A stock may have a historical P/E range of 9X – 22X, for example, and if it is now trading in the upper teens, it might be a good time to sell. You could redeploy that capital in a beaten down name, or be patient and potentially repurchase the same stock in the future at a price lower than where you sold. Of course taxes should be taken into consideration here for non-qualified accounts.
You need cash for some expected – or unexpected – expenditure. Most people invest with a specific goal in mind: buy a house, pay for school, have money for retirement, etc. As that event approaches you need to convert securities into cash to fulfill those expense obligations.
The company’s fundamentals have ‘permanently’ deteriorated. Warren Buffett has counseled many times his investing rules: Rule #1, Don’t Lose Money. Rule #2, Don’t Forget Rule #1. This statement often gets misinterpreted. He is not saying to never be down on a position – to have paper losses. He means avoid permanent capital losses. His long, successful track record is full of stock purchases that quickly lead to ‘losses’ on paper. He famously bought GE for approximately $24 per share in 2008 during the peak of the financial crisis. The stock promptly plummeted to around $6. He had similar massive paper losses with investments like GS. However Buffett understood the fundamentals of his investments, and was in it for 5+ years, not 5 days or even 5 months. Some of the purchases he made during that period – like BAC – have since made him billions. To many he looked foolish buying what appeared to be sinking ships in the middle of the worst financial typhoon since the 1930s. By being patient and focusing on long-term fundamentals, not short-term price movements, Buffett ended up laughing all the way to the bank. That said, there are times when a company’s fundamentals deteriorate and selling before further losses are incurred is prudent regardless of an emotional desire to get back to ‘even’ (AKA, the purchase price, this being just a common psychological anchor our mind plays a trick on us). Buffett realized his investment decision around Tesco was made in error, and that fundamentals at the business were not improving, so he took his losses and moved on.
Tax reasons. In non-qualified accounts, there are often legitimate reasons to sell securities to minimize tax obligations. This requires a careful analysis of realized/unrealized gains and losses within a given account, as well as how that information fits into a broader tax context. Specific security selection for consideration must also be made.
Bad Reasons to Sell
Short-term price declines. This is the primary reason most people sell – the stock price declines in the near term. As they often didn’t really even know what they were buying in the first place, price is the only measure of whether the company is doing well or not. People will even have arbitrary stop loss sale rules like sell a stock if it declines 20% from the purchase price. Imagine all of those who endured permanent capital losses during the Flash Crash when billions of dollars of stock were sold at artificial lows (lasting literally minutes) of otherwise great companies like PG which saw its price drop 30%+ in a…well, flash. Nothing fundamental had changed for PG during that brief period, yet many investors sold in a panic or due to pre-established orders. Take a cue from Buffett: only get into a particular stock if: 1) you are willing to hold for 3, 4, 5 years or more, and 2) you are willing to withstand a 50% decline from your purchase price on the way to long-term profits.
Margin calls. Leverage can bolster returns in bull markets, but accelerate losses during price declines. When the tide turns, and the water rushes out, it not only reveals who has been swimming naked, but also those whose clothing may be repossessed by their brokerage firm. Just when you should possibly be holding – if not adding more to an account – is not the time for forced selling due to margin calls.
Fear. Very few people were born with brains wired properly to invest. Being an effective investor requires turning off your emotions and acting with tremendous discipline and rationality in good times and bad. The reason bubbles and panics/crashes exist is that human psychology takes over and irrational behaviors rule the day. Eventually, however, rational facts like P/E ratios, dividend yields and the like take front and center again. Don’t take counsel to your fears, or at least know yourself well enough to put up barriers before events occur that you may get swept up in. The time to think through protection is long before the heat of passion. Take action when your mind is calm and rational, not when overtaken by irrational thoughts and behaviors. This may include taking profits in an extended bull market, having cash set aside in case a market crash occurs (so that you won’t feel the need to take action and sell into weakness) or working with a third party professional who can help you maintain your long-term strategy in the face of a crowd doing just the opposite.
Remember: selling doesn’t have to be all or nothing. A partial position sale is a viable option, as is hedging some or all of the position. Make sure to consult your professional investment and / or tax advisor before you take such actions.