It’s Not What You Buy, It’s When You Sell

A buddy suggested I write about stocks to increase readership to this blog.  Why he thinks this is a winning strategy is beyond me.  I wrote  about the same kind of stuff in a weekly column called “Strictly Business” 87 times in four years in college but I got more attention the one time I wrote politics.  Be that as that may be, since I talk about stocks ad nauseum, I figured I might as well write about it too.

I’ve been investing in the stock market for over 10 years.  In that time, I rode the tech bubble to double my life savings, went down flaming with the dot-com burst, then did a 180 in my investing strategy as I kept pumping more money into the market.  Thankfully, the last five years has been more successful than the first to the point where, at last, I’ve recovered all of my losses and then some.  Through the good times and the bad, I learned two things:  one, even a monkey can pick a good stock and two, monkeys don’t make money because they don’t know when to sell.

It’s not hard to make an decent stock pick.  You pick a strategy, establish some criteria and do some research.  A dominant player in a stable business in a booming market that’s undervalued?  Try Sabesp (SBS).  How about an established but still growing tech stock with high gross margins and good balance sheet?  Take a look at eBay (eBay).  A company that’s sure to come roaring back when the economy goes back into full swing that also returns most of its profits to shareholders?  Frontline (FRO) is my favorite pick.  A high risk Internet Company in China?  How about sohu.com (SOHU)?  Heck, you can probably even chase Apple (AAPL) like everyone else and still make 25-30% even though it’s grossly overvalued.*  Really, if you commit to doing some studying, you’ll be able to successfully pick stocks more than half of the time.

No, the real challenges of investing are in when to get out.  The exit strategy is more difficult because, having committed the money, you’ve become emotionally committed.  If the stock doubles, greed takes over.  “You’ve made the right pick,” you persuade yourself, “so ride it out for all it’s worth.”  If the stock falls 20, 30 then 40 percent, delusion sets in.  “Don’t worry,” you convince yourself, “it’ll make a comeback because if it was a good buy when you bought it, it’s certainly a better pick now.”

These responses, so natural, is also very perilous.  If you’ve made big money, you’ll miss your chance to cash in before the stock retreats.  If you’ve lost big money, you watch hopelessly as the stock continues to tumble. Emotional buying is no better than emotional refusal to sell, but the latter is more tempting because it can be rationalized as a buy and hold “strategy.”  The truth is, there are very few stocks that are worth holding onto for a decade.  Every stock, no matter how good, eventually stops increasing; that’s a simple function of valuation.  Microsoft (MSFT) and Qualcomm (QCOM) haven’t lost much value in the last five years, but they haven’t gained much either.  Any money invested in either stocks is dead money that should be funneled elsewhere.**

Of course, it’s easy enough to say don’t let emotions dictate when you sell, but then, how should you approach getting out?

There is one scenario in which the answer is obvious.  That’s when the stock sky rockets on reasons wholly unrelated to the general market performance and to valuation.  In most cases this is a takeover rumor, but it could also be some analysts’ report that speculates on something about the company.   If the stock rises over 10% on such an event, sell it.  It doesn’t matter what you bought the stock at–whether you’re selling for a loss or a gain–just get out.   I don’t believe much in “buy and hold” strategy, but I do believe that the market  “buys on the rumor, sells on the news.”  Nothing good can come out of waiting to see what will come of the rumor.  Either the rumor is true–i.e. the market has already priced it into the stock–or the rumor is false.  Either way, the stock is unlikely to do much better.

But most of the time the signs are not that obvious and the stock’s rise or fall is more gradual.  It could either be moving with the market or against it, but I think the general approach should be the same.  The only way to divorce yourself from emotions (at least for most novice investors like me) is to set a target price on the upper end and the lower end and commit to unloading a portion of the holdings when the stock hits that number.

The target prices need not be in the same range for the upper and lower end, although you can’t adjust them as the stock moves or else you will defeat the entire purpose.  If the stock is a short-term play, you may want to make your lower target 10% below your purchase price with the upper target at 20%.  If you think the stock is a long-term value play, set the lower threshold at 15% and the upper threshold at 50%.  If you think the stock is a the next Apple, set your lower target at 50% (time to give up) and upper target at 200% (cash in your income).  You can also adjust how much of your holdings you will unload based on your confidence in the pick: for those stocks you feel strongly, commit to sell only 1/3 while those with which you are less certain, sell 1/2.

Frankly, I haven’t been investing long enough to know what the right numbers and ranges are.  But the important point is that you need to have some exit strategy before you go in.  Otherwise, emotions take over and the only time you’ll get out is when you’re compelled to do so–which is not an investment strategy at all.

This “exit strategy” should, in theory, partially protect you from the downside and partially lock you in on the upside.

How will it work in actual practice?  Ask me in a year or two when I can tell you whether I successfully purged my emotions and stuck to my guns.

*  Full disclosure:  I own a long position on all these stocks except EBAY.

**  Full disclosure:  I own a long position on QCOM, despite my full awareness that I need to get out.