November 11th, 2010
The last major chapter of my book “Run with the Herd” is about Sell Rules. I’ve been writing the book off and on for about three years …. through the Financial Crises Crash and now the recovery. Probably the most difficult topic, however, remained unanswered. What are the sell rules? When do you sell stocks? It’s the most frequently asked question of readers here and elsewhere.
The book would have been finished a long time ago had I omitted it altogether rather than leaving it for the end. But I think I’ve now articulated it succinctly. “Selling is something we do to reduce risk not something we do to lock in gains.” But isn’t this one of those times when it’s really risky and we should be selling stock to preserve those gains? Actually, I don’t think so. In “IBD and Market Timing? I Don’t Think So” of October 22, I introduced the Market Security Meter and it’s still flashing Bull Green. There isn’t any market risk until market momentum changes causing the Meter changes color.
We feel the urge to sell because we begin feeling anxious and fearful that profits we watched slowly build would begin to quickly evaporate. When we begin feeling the urge to sell there’s only one thing to do: impose strict self-discipline and restraint and do nothing.
If the stock market goes up 70% of the time, then always betting against the market is a losing proposition. If you wouldn’t usually sell the market short (except when it’s clearly crashing) then why would you ever think of selling a stock (or selling a stock short) when the market isn’t crashing? That is essentially what we’d be doing if we sold stocks that we bought in the early phases of the market’s life cycle and they hit some arbitrary mental price targets of, say, 25% gains.
It was the subject of “It’s Time to Clean House” on October 18 and I can now enumerate it as “sell rules”:
- Sell to Reduce Portfolio Level Market Risk:The only time you must sell stocks is when the market is peaking, topping and entering in the Distribution Phase of its life cycle. Your decision is transformed from “which stock to sell” into “how many and how much of each to sell” in order to achieve the desired level of market risk exposure for the whole portfolio.
- You will probably sell stocks incrementally and need to adjust your risk exposure target several times as the market moves down. Pick a target percentage of cash that’s appropriate for various levels of the market.
- Since the objective is to reduce exposure, increase cash and bring the portfolio position to desired level risk, it almost doesn’t matter which stocks you sell or in what sequence. The goal is to reduce risk and whether the cash is generated in all in several stocks or through portions of many stocks almost doesn’t matter.
- When the portfolio level risk is acceptable, do nothing.
- individual stocks where risks associated with that stock appear to have increased:
- Sell a stock that you may have bought incorrectly (i.e., too early, too late after a breakout buy point, a stock pattern fails or you erred in reading a chart incorrectly) and performance disappoints shortly after the purchase.
- Sell any stock that has a surprise including such events as reporting an accounting error, a badly missed earnings announcement, a significant top management change or terminated merger and acquisition discussions (Cisco’s announcement yesterday meets this rule).
- Sell a portion of a stock position that, because of a large run, ends up comprising too large a percentage of your total portfolio and thereby increase its risk (a large position in NFLX or PCLN are examples).
- Reduce exposure to an industry group if it falls out of favor (for-profit education stocks come to mind).
- Sell a stock that has underperformed the market and you expect to continue doing so over the near term future as measured by its relative performance during the time you’ve held it (of course there are many of these I could name).
- Sell a stock opportunistically to generate funds to take advantage of a stock you believe has relatively greater potential than the successful stock position you’re selling. I discourage this because it often results in nothing more than account churning and ultimately worse performance for the total portfolio over the long run.
This sell discipline feels comfortable, fairly easy to follow and, I believe, will maximize my profit opportunities, prevent account churning and avoid significant losses and draw downs in account value. The only question is whether I have sufficient self-discipline to follow it.