Learning when to sell a stock might be the single most important skill you can master on your investing journey. It allows you to secure profits, minimize risk, preserve capital, and pursue new opportunities. If you want great results in the financial markets, you need to have a clear strategy for when to sell a stock.
Market downturns or sudden stock fluctuations can impact us emotionally and cloud judgment. The decision to sell, whether to take profits or cut losses should be made by dispassionately adhering to your predefined strategy.
Establish Clear Goals Ahead of Time
Before purchasing a stock, it’s essential to have clear investment goals. Are you aiming for short-term trading profits or long-term growth? This will significantly influence your selling strategy. Define what success looks like for each investment and make sure the risk-reward ratio is sufficient before you buy.
Once you've found the best stocks to buy, here are 8 rules to help traders and investors know when to sell a stock.
1. Sell When it Hits Your Price Targets
Setting price targets is one of the most straightforward strategies for when to sell a stock. Determine in advance at what price you will sell to take profits or cut losses.
• Upside Target: Decide on a price point where you will take profits if the stock appreciates to that level.
• Downside Target: Establish a point to sell and minimize losses if the stock price falls to a certain point. Consider a stop-loss order to trigger the sale automatically.
• Trailing Stop-Loss: Set a stop-loss at a fixed percentage below the current market price. Your price target moves up automatically as the stock does. This provides a safeguard against significant declines while still allowing for potential upside. Stop-loss strategies have the added benefit of taking the decision of when to sell a stock out of your hands.
You can choose to sell all or a portion of your shares at each target and create additional targets based on your risk tolerance and objectives.
2. Sell When Business Fundamentals Change
We must know the prospects of a business before deciding when to sell a stock. Today's business landscape evolves faster than ever and future success is never guaranteed. Top companies face stiff competition which can erode their competitive advantage and returns over time. New technologies can disrupt existing business models, threatening the very existence of companies slow to adapt. Legal issues, scandals, and management changes are other pitfalls known to severely damage a company's prospects and performance.
It’s crucial to differentiate between short-term setbacks, like a poor quarter, and more sustained changes that could signal long-term problems within the business. If it's the latter, consider it a good time to sell.
3. Sell According to Technical Indicators
Technical analysis uses stock charts to predict future price movements. By understanding and applying certain key indicators, you can make more informed decisions on when to sell a stock. Here are 5 valuable technical indicators to consider:
• Key Moving Averages: Moving averages are popular tools in technical analysis. If a stock’s price falls below a key moving average, such as the 50-day or 200-day moving average, it might indicate the uptrend is reversing. For many traders, this crossover signals a good time to sell.
• Relative Strength Index (RSI): The RSI is a momentum oscillator that measures the speed and change of price movements. An RSI above 70 indicates that a stock is overbought and might be due for a pullback. This doesn’t necessarily mean you should sell immediately, but it suggests the stock may have risen too far, too fast, and a correction could be near.
• MACD (Moving Average Convergence Divergence): The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price. When the MACD line crosses below the signal line it's called a bearish crossover, and many traders and investors consider this a strong indicator of when to sell a stock.
• Bollinger Bands: Bollinger Bands are a volatility indicator that consists of a middle band (a simple moving average) and two outer bands (standard deviations above and below the middle band). When a stock’s price moves outside the upper Bollinger Band, it can be considered overbought, indicating it could be a good time to sell.
• Trend Line Break: In an uptrend, the trend line is drawn along the lows of the price chart. If the stock price breaks below this line, it can indicate the stock's upward momentum is weakening. This break is often used as a signal for when to sell a stock and exit before the price declines further.
4. Sell When the Valuation is Too High
Market enthusiasm, hype, or herd mentality can sometimes drive stock prices to levels not supported by the company’s underlying fundamentals. In these instances, a stock can trade beyond what can be justified by even the best estimates of future performance. Paying attention to excessively high valuations can help investors know when to sell a stock and avoid potential losses when a market correction occurs.
Consider key valuation metrics such as:
• P/E Ratio (Price/Earnings): The P/E ratio is one of the most commonly used valuation metrics, measuring the current share price relative to its per-share earnings. A high P/E might indicate that the stock is overvalued, or investors are expecting high growth rates in the future.
• PEG Ratio (Price/Earnings to Growth): Adjusts the P/E ratio for the company’s expected growth rate. This metric helps determine if a stock is valued correctly relative to its growth potential, offering a more nuanced view than the P/E ratio alone.
• EV/EBITDA (Enterprise Value to EBITDA): This ratio compares the company’s enterprise value to its earnings before interest, taxes, depreciation, and amortization. It is particularly useful for comparing companies with different capital structures and provides a clearer picture of operational performance.
If these ratios exceed its historical averages or the ratios of competitors and market benchmarks, it could indicate the price is unsustainable and facilitate your decision of when to sell a stock.
5. Sell When You Find a Better Opportunity
Investment opportunities are abundant, and sometimes you might find a stock with better growth potential or a more attractive valuation than one you currently own. Selling a stock to reallocate capital to a more promising investment can optimize your portfolio’s performance. As the legendary Warren Buffett said, "The best thing to do is find a wonderful business and buy it. But if you find a better opportunity, you should take it."
Compare the risks and rewards of the new opportunity with your existing holdings before you decide when to sell a stock. It’s essential to perform thorough due diligence on the new company and ensure it aligns with your investment strategy and goals.
6. Sell to Rebalance Your Portfolio
Periodic portfolio rebalancing can help you decide when to sell a stock after big gains. This strategy ensures your investment mix is aligned with your financial goals and risk tolerance. If one stock has grown significantly and now represents a larger portion of your portfolio than desired, selling some shares to rebalance can help maintain a healthy asset allocation and reduce your overexposure to one stock.
Rebalancing can also help you lock in gains from overperforming stocks and reinvest the proceeds into underperforming ones with growth potential. This disciplined approach helps manage risk and maintain a diversified portfolio, which is crucial for long-term investment success.
7. When to Sell a Stock for Tax Reasons
Managing your tax liability might factor into your plans of when to sell a stock. Tax-loss harvesting involves selling investments that have declined in value to offset gains from better-performing stocks. For example, if a stock lost $5,000 in value and another has gained $5,000, selling the loser will offset the gain from the winner, effectively reducing your taxable income and lowering your tax liability.
Another strategy is spreading the sale of investments over multiple tax years. This can ease the burden of any individual tax season by distributing capital gains across a longer period. You might sell parts of an investment at the end of one year, another portion the following year, and the final part at the start of the third year. Proper tax planning can help you decide when to sell a stock, enhance your after-tax returns, and benefit your overall financial goals.
8. When to Sell a Stock for Personal Reasons
Sometimes, personal circumstances may dictate when to sell a stock. Whether it’s funding a major purchase, covering unexpected expenses, or reallocating funds for retirement, personal financial needs can influence selling decisions. Ensure these decisions align with your overall financial plan and long-term investment goals.
It’s important to balance your immediate financial needs with your long-term investment objectives. Selling stocks for personal reasons should be done thoughtfully, taking into consideration the impact on your portfolio and future financial security.
Don't Sell Just Because:
• The Stock Has Increased in Value
Selling a stock after a large price increase can mean missing out on future gains. Companies like Apple and Microsoft have rewarded long-term investors significantly. Often the bulk of your portfolio's gains come from a handful of winners. Consider only selling partial positions on your biggest gainers so you retain exposure to potential market leaders.
• The Stock Has Decreased in Value
Similarly, selling just because a stock has decreased in value can be detrimental. If the underlying fundamentals of the company remain strong, a price drop might be a buying opportunity rather than a reason to sell. In October of 2022, Meta was at a 52-week low trading below $100 per share. Just sixteen months later it was near $500 per share.
• Economic Forecasts are Gloomy
Economic forecasts can be highly speculative and influenced by events that won't impact a company’s long-term performance. Investors should focus on the company’s fundamentals rather than making hasty decisions based on economic pundits.
• Short-term Swings are Extreme
Markets are volatile, and short-term fluctuations are normal. Making decisions based on short-term market movements rather than long-term prospects can be counterproductive.
Conclusion:
The rules of when to sell a stock are easy enough to follow in theory. However, it might be a different story when you are emotionally invested in a stock you own.
When your stock pick soars you might be afraid to sell and miss out on future gains.
If your stock is sinking you might convince yourself it will rebound and prove your initial thesis correct.
Remember that even the best investors make mistakes, so keep your pride aside, and don’t worry about being wrong or trying to predict the future. The most important thing is not to let a small loss turn big or to watch a huge gain evaporate by not following your rules.
Selling stocks takes discipline, and mastering the art of knowing when to sell a stock will significantly enhance your financial success.
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