Elsewhere in this guide we discuss the importance of discipline in investing. Selling at the right time, partially or completely, is part of that discipline. Our emotions can carry us away, leading us to hold onto stocks for too long. It is particularly challenging, and even more important to understand why and how to sell, when you are under water.
Learning when to sell stocks at a loss is an important lesson for all investors. Admittedly not a fun one, but one that will serve a savvy investor well. Implementing it will depend a lot on what type of investing you’re doing.
Losing trades are an inevitable part of investing, so it’s important you have a strategy for managing them.
It’s especially important when the markets run into periods of sustained selling.
Put simply, there are times when you’ll need to sell stocks at a loss to avoid “holding and hoping,” as Cabot Growth Investor’s Mike Cintolo would put it.
Before we get too much further into this, it’s important to acknowledge that selling an underperforming stock looks very different for short-term momentum traders and long-term investors.
A breakdown in a momentum stock (where it breaks below key support or moving averages) may be little more than a blip for a value-focused investor who’s more concerned with fundamentals and price multiples.
In fact, a 10% or 20% dip that may chase out the traders could easily see long-term investors doubling down.
So, the first thing to consider if you’re about to sell a stock at a loss is why you bought that stock in the first place.
Momentum (Technical) Traders
If you’re a momentum-driven growth investor, your approach should be similar to that taken by Cabot’s growth advisories:
Be patient. Let your winning stocks keep winning.
Take partial profits on the way up. That way, you’ll never have a total loss.
Set a loss limit. This will vary depending on the stock and your risk tolerance, but we generally suggest between 10% and 20%.
That seems simple enough. You buy a stock for $15. It gradually rises. You sell enough to regain your initial investment. The stock hits $30. Then it drops to $28. No big deal. There’s no bad news, so people are probably just taking some profits. Plus, we know that stocks go up and down over time. It hits $40. This is good! You sell a little more and take some profit.
In a perfect world, the only selling you’re doing is profit-taking. But in the real world, there will probably come a time when you have to consider letting your remaining stake in a stock go and moving on to greener pastures.
Percentage-based stop-losses are one approach to handling stocks that have started heading south.
You can also consider looking for technical support levels like round numbers, moving averages, or prior chart setups.
One useful rule of thumb—especially if you’ve taken some profits on the way up—is to avoid letting a winner turn into an overall loser.
In other words, if you’ve taken partial profits, don’t let your remaining stake dip to a point where the losses from that chunk of shares cancel out your prior gains.
Fundamental Investors
The key difference for a long-term investor is that the criteria that initially made your stock a buy are much different from those of a momentum trader.
Dividend yields rise as stock prices fall; price-to-earnings and price-to-sales ratios get more attractive when stocks get cheaper, not less.
So, instead of taking your selling cues from price action, take them from the fundamentals that made the stock a buy in the first place.
If a company cuts (or is at risk of cutting) a dividend, that’s a signal to reassess the position.
By that same token, if a company’s earnings prospects are weakening, you need to consider whether it still makes sense as a long-term investment.
But don’t forget: even long-term investors can fall victim to that “hold and hope” mentality.
If a stock is failing to do what you hired it to do (show continuing momentum, deliver earnings growth, pay a dividend, etc.), you may need to cut bait, even if it’s painful to take a loss.