When Should You Sell a Stock?

by Nov 28, 2019Personal Finance

Hope, greed, belief, disbelief, and fantasy are some of the mixed emotions an investor has to fight when it’s time to sell a stock. Much fewer emotions go into buying a stock. 

Since we are scientists at heart, is there a less emotional and more scientific way to decide when to sell a stock?

Of course there is. It’s called a “stop” or a “stop loss.” It relies on basic math.

A stop is the price at which you will sell a stock, regardless of what might be happening to the company, your mood, the economy, or the stock market. A “trailing stop loss” is a particular type of stop loss (arguably the best type) that adjusts higher as the share price of a stock rises. This allows you to lock in profits.

It’s a great way to follow an important rule of investing: Limit your losses and preserve your profits. In other words, “cut your losers and let your winners ride.”

Let’s say you buy shares of Amazing Brownie Company (ABC) for $50. The stock price steadily climbs to $100. That’s wonderful, you just doubled your investment! Now you need to protect your profit.

Setting up a trailing stop means that you pick a percentage, say 25%. If the stock price goes down by 25% below its highest closing price, you will sell the stock without question or overthinking. Just sell.

In our example, ABC stock is now worth $100 a share. So your trailing stop is $75, or 25% below $100. So if the stock falls to $75, you sell it. Period.

Now let’s say business is good and ABC keeps climbing. It is now worth $200 a share. Your trailing stop is still 25% below the highest closing price, which is now $150. So when the stock drops to $150 a share, you sell.

Sure, losing $50 per share is not fun. Problem is, you can’t predict whether the price of ABC is going to rise to $300 or plummet to $30. You need to protect your profit. As they say on Wall Street, “nobody ever went broke taking a profit.”

Having a consistent strategy, in the form of a trailing stop, takes the guesswork out of selling. There is no thinking involved, no emotions, no falling in love with a particular company. When you hit your trailing stop, you sell. End of the story.

One more suggestion: instead of watching your stocks like a hawk throughout the day, watch them in the evening, after the market closes. Ideally, trailing stops should apply to closing prices, not intraday prices.

What’s so magical about the 25% number? Nothing. (Well, there is something, as discussed here).

If a stock is very volatile, you could choose a higher trailing stop, say 33%. Or, if a particular stock keeps climbing and you are anxious about the market conditions, or you don’t want to risk losing 25% of your profits, you could set it at 20%, or even 10%. We could debate all day about the best percentage.

Instead of debating all day, keep it simple: 25% is a good compromise. It’s easy to remember, it allows some volatility, and it will always prevent a catastrophic loss.

Of course, there are many other reasons that have been used to sell a stock, but they tend to involve emotions or technical data:

  • You should sell when you realize that you made a mistake (that’s a big emotion to overcome).
  • You should sell when the price-to-earnings (P/E) ratio is insanely high (this is debatable, as a high P/E ratio may not prevent the stock price from climbing higher).
  • You should sell when the stock reaches your price target (this is tricky at best).
  • You should sell when your investment priorities have changed (e.g., your risk tolerance decreased).
  • You should sell when the company’s fundamentals go south (e.g., profit margin, earnings, cash flow).
  • You should sell when a better opportunity comes up (this can be very subjective).

Investing is both an art and a science. Use trailing stops to take emotions out of your investments. Your finances will be better off, and you will sleep much better.

Phil Zeltzman, DVM, DACVS
Meredith Jones, DVM
Co-Founders of Veterinary Financial Summit