How to Know When to Buy Or Sell Stocks - Part 2
An Acceler8now.com Investing Education Resource July, 2007
The Selling Decision
Okay, you have done your research and analysis, and based on the outcome, you have invested in stocks that have strong fundamentals and meet your buying criteria. Two things are possible:
- You get proved right by subsequent events, meaning that you really get that opportunity to make a killing;
- Your best judgement doesn't get borne out by reality. You have misfired, somehow, meaning that results turn out to be anything but what you anticipated.
Either way, you need to keep your eyes on the ball, because further decisions will need to be taken - whether to continue to hold or to sell off and at what point. Given the undeniable sentiment that could be there with share ownership, you will need a clear-headed attitude to this, to ensure you optimise returns. That requires vigilance and resolve. More importantly, it needs to be parameters-driven - that is, you need a set of decision-rules that place the decision process out of the realm of sentiment. This is business, you know. So, what factors should trigger your exit? We may not have an exhaustive model here, but these are variables that should figure in decision model:
- You Got It Wrong, So Cut Your Loss
You did all the research and thought you had it on target, but, surprise, surprise - it hasn't played out that way. Instead of moving up, the stock is sliding. Do you watch your money slide too, just because you can't come to terms with a mistake that is both human and common? No, it happens all the time. No expert gets it right always and you only need a few good wins to achieve the breakthrough you want. So, cut the loss and move on. At what point? That's why you need a loss limit, pre-set. A suggestion: keep it at below 10% of the purchase cost. On a stock bought at N100, that limits it to N90 or above. For more effective response, two limits are better: first, a trigger point that puts you on red-alert (say 5% drop) and then a no-miss sale-action point (say 10%). With hard work, you will recover that loss elsewhere, sooner than you think. Analyse the situation and if there are lessons, learn them, but get your money working elsewhere.
- Ding-Dong Performance
What if the stock hasn't really nose-dived but is just not living it up? The implication here is that your money is just sitting, not losing value (except to inflation), but obviously not generating wealth for you. Selling off isn't as desperate a case as when your investment is whittling down, but for how long will you hold out? That decision will have to be made as to how much time it's justified to give this stock to see if it wakes up. That allows you to do more evaluation about the fundamentals of the company. If the stock isn't going to turn in a good return in a reasonable time, other opportunities should exist. The bottom-line: switch, if you can't justifying carrying a seeming dead weight.
- Ridding a Winning Stock
This time you got it right and just as projected, the stock is heading nicely up. That's what the investor prays for all the time. There are traps, all the same.
One, because you might be afraid that the climb could reverse suddenly, you could sell off even before the real drive has started. That hasty, panicky action cuts off so much of your potential profit. You possibly won't forgive yourself, but the harm is done, especially if you don't have the nerve to re-enter.
Or you hang on expecting a longer stretch of a bull run, but find, suddenly, that the price is on the decline. You wait, believing it's a consolidation before another burst of upward ride, but alas, it goes heading down.
These things happen to investors all the time. How can you manage the success ride to utmost advantage, selling only when you really should - at the peak or close to it? Here are strategies you can apply:
- Work With a Set Profit Margin
You can take a conservative approach that doesn't aim to hit the price peak. You simply pre-set a fair margin on your purchase price and work on the basis of earning multiples of that margin from various stock purchases across, say, one year. All will add up to a sizeable chunk. If you aim for 20%, for instance, don't risk any loss by pursuing more upward ride, after this point. Sell off, log into any stock that is possibly just heading off the block and shoot for another 20% gain. If you match this with a strong limit on losses, you will soon be getting somewhere.
- Ignore Peak Price but Scale Out
Considering the difficulty of reading when the peak is at hand and the risk of losing out if the market gets bearish, you can gradually scale out, which means taking your profits on a scaled-up basis. This is like climbing stairs and at each level, you offload a tranche of the stock. When you do, you have some realised profit, already in the kitty, and still some stock left to ride any further price advances. This way, you probably won't regret your eventual outcome: you earned some profit at each stage, limited your potential loss thereby and still remained open to capture more profits. This is partial profit-taking, stage-by-stage. What proportion do you sell at each point and how many sale-levels do you want to set? Make that decision, depending on your risk tolerance.
- Take a Chance, Ride Out the Gain
That's what every investor would ordinarily want, except for the risk inherent in waiting. If the price starts tumbling, you may be unable to sell (everybody wants to sell), meaning you're probably stuck with it, taking some haemorrhaging. Riding it up therefore requires careful monitoring and the ability to read market patterns. It demands tracking of volume and price trends to observe features that may indicate increasing steam or a weakening of the demand pressure. This is charting, in the area of technical analysis. This has to be supported with monitoring other important parameters. Are sales and earnings and their growth rate, rising or falling? Is the industry booming or shrinking? What is happening to other stocks in the sector? Short of this kind of careful analysis, you will possibly depend on market buzz, which clearly is a weak and dangerous approach. Your strategy in all this is to sell off the moment you see an indication of weakening demand, or, of factors that have a strong chance of inducing a negative market response.
 What must be clear is that your prospect of making good money is a function of how well you buy stocks and how well you time your sales. Put differently, it depends, in the end, on how much you create and ride your gains and how quickly you cut your losses. The buying and selling decisions are therefore crucial for your success. They are also a bit tricky since it's not easy to predict the market. It's easy to be wrong, but this shouldn't deter you from taking action - even experts misread the market, sometimes. It therefore only means you must keep working on your understanding of the workings of the market. You must keep learning. One way is by continuing to read up resources that impart relevant knowledge. Another, you must practise. Experience remains the best teacher. So, get into the fray, take a few knocks if you must, but keep your eyes on the goal. Time will come when you knock off a few transactions that will get you wondering if it was so easy to get wealthy.
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