If you do not have an exit plan for your investments, you are not alone. Setting some guidelines and improving your selling decisions will increase your returns and reduce the risk in your portfolio. In part 1 I explained my investment strategy and in part 2 I elaborated on some of the errors most investors do after they have purchased a stock. In this part I will give you some of the rational reasons for when to sell a stock.
You purchase a stock and are happy about the company and its prospects, but suddenly the stock doesn’t act according to your plans. The share price rises quickly and beyond the levels you even thought possible in the short-term or the price plummets and you are in the red even before you are able to check whether the shares are recorded in your portfolio. A recent study may have found the reason why active portfolio management underperforms the general market and why most investors are better off investing in index funds. In some cases, the investors are better off by selling their holdings completely at random even if they are the best stock picker out there.
To be honest, I have made some mistakes over the years when I have decided to sell a stock, but I have also avoided some even bigger mistakes. I have missed out on great profits when I have tried to scalp or day trade a stock, only to see the share price keep on going upwards (remember part 2 and the part about anchoring?). On the other hand, I’m not afraid to realise a loss, which have saved me several times.
What I have learned is that in the cases where I sold a stock (only to see the share price increase subsequently) I had an unrealised profit; the company showed no sign that they had lost their competitive advantage and I felt greedy!
In the cases where I ended up realising a loss, I did not do my initial homework, the company had a high dividend yield (which was not sustainable in the long run) and the company sliced its dividend.
Keeping in mind the research article earlier it is important to have some rules for when to sell a company. Even though you follow a buy-and-hold strategy you must maintain your portfolio and keep the weeds out.
Introducing “The Sell Checklist”
First off, the number one rule for a dividend investor is to sell a stock that reduces its dividend.
If a stock you own reduces its dividend, it is paying you less over time instead of more. This is the opposite of what should happen. You must admit that the business has lost its competitive advantage and reinvest the proceeds of the sale into a more stable business. For a dividend growth investor, one should also consider getting rid of stocks that are not increasing its dividends since this may be a signal from the company that their business has stagnated, the competition has increased or that their dividend level is not sustainable in the long run.
Another reason to sell is when buying the stock was a mistake in the first place or there are alternative investment opportunities with better prospects than your worst performing stock. You must trim the dead weight in your portfolio because it will drag the performance of your overall portfolio down.
Diversification and position sizes
In my portfolio a company cannot constitute more than 10 % of total holdings. The reason for this is because 90% of the benefits of diversification come from owning just 12 to 18 stocks. For a dividend investor one should also take into consideration how exposed your total portfolio is to a dividend cut or dividend reduction by a company. If a large share of your total dividend income is paid out by one company, you become highly dependent on that the company doesn’t slice its dividend. Another positive side effect of setting targets for how much a company can weigh in your portfolio is the positive effects that comes from rebalancing (remember the study mentioned earlier?). Negative effects of incorrect position sizes are that you increase personal errors, violate your own rules and make quick and irrational decisions due to the strong influence (bias) you have from the size of the position.
Increased volatility is a signal that the company is not as stable as previously and might be an early sign that the future earnings and dividends are not as safe as it used to be.
Once again, investors are greedy, and they overreact to good news. If a stock has reached a silly and unsustainable price it may be a rational decision to reduce your position size or sell completely.
Investment journal: If you in retrospect are unable to tell what went wrong, you will most probably not make a profit in the long term. After some time, you will most likely have forgotten why you decided to part with a stock and the reasoning behind your choice. Therefore, in my opinion, it is important to keep an investment journal where you enter your initial purchase decision, cost price, dates and your sell decision. Hopefully you will not make the same mistake again…