After my Investing column on Risk Alignment, one of my friends who used to be a devout “Buy and Hold” investor called me to let me know he decided to sell most of his stocks to prepare for his first child’s entrance into college – and especially those upcoming tuition bills. He credited my column for helping him to recognize that the change in his life circumstances deserved a change in investing philosophy. Outside of my friend’s personal situation, his dilemma represents a classic issue in investing – why and when do you sell? Depending upon your philosophy, there may be corollary decisions to make as well, such as how much do you sell and do you sell it all at once? Let’s dive in deeper and profile some basic strategies.
As my friend discovered, a key reason to sell beyond your basic investment strategy is a transition. Transitions can be about your personal life circumstances or it can be a translation related to the investment. Life transitions usually involve a big expenditure (wedding, college, retirement, house purchase, etc.) and will require a lot of available cash. You can wait until the last minute to sell your investments to make the purchase, but then you may find yourself vulnerable to market swings.
For example, let’s say you need to pay $50,000 for college tuition and let’s ignore taxes and commissions to make the math easier. Let’s first take a time machine to 2008 and assume you have a fall 2008 payment of $25k and a winter 2009 payment of $25k. For the fall of 2008, you go to your brokerage account and sell 200 shares of SPY (S&P 500 index) at the 8/1/2008 market price of $126.16 per share and raise $25,232. On February 2, 2009, you go back to your brokerage to raise the other $25,000 and SPY stock has fallen to $82.58 and you need to sell 303 shares of SPY to raise $25,021.74. If you had sold 400 shares in 2008 instead, you could have held on to 103 additional shares which would be worth $30,610.57 dollars at today’s price of $297.19 per share! Of course, the market crash of 2008 is an unusual circumstance and the difference is usually not as extreme.
So let’s be more fair and look at 8/1/2018 and 2/1/2019 and assume you are still raising $25,000. On August 1, 2018, SPY closed at $280.86 per share so we only had to sell 90 shares to raise $25,277.40. This winter, the market dipped again, just not as strongly as 2009. When we went back into the brokerage on February 1, 2019, and SPY now sell for $270.06 per share so you have to sell 93 shares instead of 90 to raise $25,115.58. At today’s price of $297.19, those three extra shares are worth $891.57!
Naturally, if the price had continued to go up instead of dipping, we would have benefited from having higher prices and it would have seemed smart not to sell. If you can sell high, great. However, timing the market is very difficult, so what we are really trying to address, is risk. In both of the scenarios above, we implied that there is some unsold stock. But what if you only had 400 shares of SPY in 2008? When 2009 rolled around, you simply wouldn’t have the money to pay for the tuition any more! It is better to schedule your exit from the market in advance so you can plan more carefully. The Motley Fool recommends having 3-5 years of expenses available outside of the stock market. The fundamental idea is to make sure you can weather a recession without having to liquidate investments at a low point because the cash you need to live is already in hand.
Industry transitions can be summarized as a change in understanding of the industry or of the specific company you own. This change in understanding can be related to financial issues, product issues, or even a simple loss of faith.
Industry wide changes in understanding typically result from either a change in how you perceive the entire industry or how your specific company exists within the dynamics of the industry.
Example 1: Photographic Film
Most people younger than 30 cannot remember taking photographs with a film camera and the vast majority only know taking pictures with their phones. However, before 2000, film cameras dominated the world and Kodak was king of the hill over Fuji Film, Polaroid, and other minor players. Their stocks were powerful and Kodak was considered a stable, safe stock. Of course, in hindsight, we can see the weaknesses as digital cameras began to be introduced in the 1990s, but there was no significant loss of market share until phone companies such as Apple included a camera on the phone that rivaled the quality of film. The entire industry was crushed by this transition and investors fled these companies quickly.
Example 2: Energy Industry
In 1985, Houston Natural Gas and InterNorth, both small regional energy companies, combined to create Enron. Enron started off as a natural gas pipeline company before it began to diversity into electric energy, energy trading, communications, and pulp and paper. At the time, Enron was a small company that wasn’t noteworthy, but by the 1990s Enron’s high profit margins and reputation as a transformational energy trading company completely changed its reputation. Enron transitioned to the status of a rock star energy company and investors started to buy its stock. It became the most popular energy stock to own and Enron’s value soared. For six straight years Fortune magazine named Enron “America’s Most Innovative Company,” but then Enron’s position in the industry went through yet another transition. In 2001, it was revealed that their CFO had been much more innovative than the business and that Enron’s amazing profitability was due to fraud. This tanked the stock and destroyed Enron. This transformation drove some people out of the Energy category, but some people just fled to less flashy stocks in the category.
For an example of product change, the classic example is cigarettes. Once people woke up about the dangers, many people sold their stock on principle alone. The companies remain wildly profitable, but many people refuse to own the stocks which dampens their market performance. A more modern example would be Boeing. Their recent troubles with their airplane software has been associated with several highly visible tragedies. Boeing stock has dropped from a ~$440 per share price in March to its current price around $350 per share. The fact that Boeing’s stock price remains relatively strong indicates that the majority of the stockholders have not let the challenges with Boeing’s current products transition their generally strong opinion of Boeing’s future. The fact that the stock dropped ~$100 per share indicates that a significant minority of stock owners did let the product troubles change their perspective and led them to sell the stock.
Loss of faith is more subtle. There may not be any single financial or product issue that causes the transformation. Instead, it may be a slow, nagging erosion of confidence in the company or in the principles behind which the operate. For me personally, Facebook and Flamel Technologies represent my best examples for losing faith in a company.
After years of trying to resist Facebook, I finally was convinced by a 2016 Motley Fool recommendation that raved about Facebook’s advertising revenue and captured audience. While I have never personally clicked on a Facebook ad, the numbers reported on Facebook’s annual reports were very convincing. I made a small purchase of 10 shares of stock at about $100 per share (~$1,000 total). While there were several scandals involving Facebook data leaks and data misuse, I held the stock into 2019 because it was performing well and Facebook’s financial numbers continued to hold. But I could no longer take pride in being a Facebook shareholder. When the stock neared $200 per share, I sold 5 shares at $191 for $955 in total return. If is subtract this from my initial investment, I now have 5 shares that were purchased for the equivalent of $60 (including commission). This basically makes it risk free for me to hold the stock so I don’t have to have much faith to retain it.
Flamel Technologies was another Motley Fool recommendation from 2005 and was a French pharmaceutical company with a technology for time-released dosing of medication. Originally, I purchased 50 shares at ~$19.50 per share, but I couldn’t admit that I had made an impulse buy, so when the stock dropped below $10 per share, I purchased another 150 shares. Now I had $2,500 tied up in this pharma stock that kept promoting how it was selling its technology to company A or B and that they would be going into drug trials ‘next year.’ In 2014, I finally lost faith that the company would ever really launch or recognize strong sales, so when the stock finally climbed back to $10 per share, I sold my stock for a net loss of $400 bucks. I felt really disappointed and foolish. The drug companies may eventually take the technology and make a ton of money, but not as Flamel. Flamel Technologies merged with their own subsidiary and changed their name to Avadel Pharmaceuticals PLC. When I looked at the stock this week to write this column, I find that many people lost faith like me! The stock now trades below $3 per share, so I’m comparing my -$400 return with a potential -$2,200 return and I’m suddenly feeling pretty good!
Beyond transitions, there are specific strategies for selling stocks. You’ll notice in my Facebook and Flamel examples, that I used different strategies. For Facebook I sold half, for Flamel, I liquidated. Partially this is a reflection of my level of lost faith, but partially this is simply a reflection of my own greed. I was sick of losing money with Flamel, so I dumped it. I liked making money with Facebook, so I sold half to get my money back and kept the other half to see if I could make any more. If you have a small amount of money invested, it generally makes sense to simply liquidate your position. When I sold my facebook, my $10 commission made up 1% of my profits and I was trading in an IRA account, so taxes did not chew up more of my return. If I had been trading hundreds of shares, then liquidating the position might actually affect the short term prices on the market. Therefore it is sometimes better to schedule sales of the stock over time so that you don’t have to worry about market timing or affecting the daily prices.
Timing the market to buy low and sell high is very hard. Day traders try to do this every day and make enough money to make a living. Day traders generally buy and sell stock in the same day and rarely keep the stock overnight. This is too much stress for me. First, I recognize that I do not have the same information as professional investors, so I need to work harder to convince myself that a stock is a good buy. I rarely buy stocks at their high because I don’t have confidence they will keep going up. I hesitate to buy stocks at their low because I fear they will go down. Although I do not always do the deep financial analysis, I usually take the time to do at least a cursory analysis of the company’s financials before I purchase so I need to work on a much longer time horizon than tomorrow.
Of course the other end of the spectrum is the devout Buy and Hold proponent. They don’t buy a stock until they decide they really must have it and then they try not to sell. The Motley Fool investor services generally advocate a Buy and Hold philosophy and my wife and I tend to skew in this direction as well. Ultimately, this does not mean we never sell. It just means we like to buy stocks we believe in and hold them until we experience a transition point (as described above).
There are pros and cons to both extremes. Short term investors keep more cash because they tend to go in and out of the market quickly. This means that if the market crashes, they will jump out and lose less money than someone who sold at the bottom. Long term investors tie-up cash and can see some investments crash and become worthless. However, if they are careful about their investments, they can weather short-term pessimism and keep their investment until it recovers.
Short term investors move quickly and base their decisions upon the latest news and stock prices. This means less homework is required for the short term investor to figure out if the company is good. In my opinion, this is driving short-term performance expectations on Wall Street because the big investment banks tend to be short term investors who don’t want to do homework. Long term investors know they are buying for a long time, so they dig into the stocks and products more deeply. While this is more effort, it usually helps long term investors to sleep better at night.
Short term investors may limit risk by jumping in and out of the market, but taxes and commissions often erode their profits. Picture a train riding up the mountain and a guy who keeps jumping on and off the train. They expend so much energy (taxes and commissions) to keep pace with the train compared with the long term investor who just rides the train.
In between these generic extremes is a selling strategy to balancing a portfolio. The Motley Fool often bags about their 10-baggers or stocks that have increased 10x the original price. Buying a super-growth stock, such as Amazon, can lead to having a huge % of Amazon in your portfolio – not because you bought that percentage, but because it has simply grown to dwarf the other purchases! While you may firmly believe in Amazon’s future, there is always the risk that you are wrong. After all, there were many people who firmly believed in Enron’s future right up until their accountants were caught shredding evidence.
To balance the portfolio, pick a maximum percentage you are willing to allow any single stock to be in your portfolio and sell down to that amount. The amount will depend upon your risk appetite. If you are willing to lose 80% of your money because you really believe in a stock, then 80% is the target. If the most you are willing to lose is 20%, then 20% becomes the target. However, you have to recognize that if you are currently at 80% and you are going to sell down to 20%, then you will no longer be able to benefit from further rise of that stock for the 60% of your portfolio you are about to sell. As I mentioned in the Risk Alignment column, the goal is to sleep at night. If you are not sure, then slowly sell the stock until you are comfortable. If you are at 80% and think that 20% is better, sell down half and see how you feel at 50% of your portfolio. If you are still uncomfortable, sell the other 30%. If you are less certain, start selling 10% a month instead.
Of course, all this depends upon having enough of an investment portfolio to really need adjustment. If you have $10,000 in investments, it is best to simply buy and hold because commissions and taxes may outweigh the risk issues for your portfolio. My commissions generally are around $10 a trade, so I want to make at least $100 in profit above the commission. It is a purely arbitrary number, but it forces me to be more disciplined about when I buy and sell the stock.
A more active and nuanced method is bookend investing. Using bookend investing, you pick a percentage range or a dollar amount range for the stock and keep your investment within the bookend range. Again, this depends upon having a large enough portfolio so that commissions and taxes don’t eat up all of your profits. I don’t use this method because I don’t feel confident enough in any one investment to take a large position worth establishing a bookend portfolio. I personally think it should only be done if you are looking at individual stock investments of more than $10,000 and at least 500 shares. To illustrate the method, let’s consider a bookend investment in 3M (MMM) and Retail Opportunity Investments Corporation (ROIC).
Example 1: 3M
Stock price – $165 / share, 500 shares = $82,500
For this example, we’ll set the bookkends at $70,000 to $100,000. The stock is currently at $165, but if it drops to $140 / share, the 500 shares will only be worth $70,000, so the strategy would require a purchase of 100 shares which would bring the portfolio up to $84,000 with 600 shares. Then with those 600 shares, when the stock price increases to $170 per share the portfolio will be up to $102,000, so we would convert 100 shares to cash ($17,000) and the portfolio would drop to 500 shares and $85,000.
Example 2: ROIC
Stock price – $18 / share, 700 shares = $12,600
For this example, we will set the bookends at $10,000 to $15,000. Since the stock is low priced, this one has to swing a bit more to trigger the bookend action. If the price rises to $22 per share, the total portfolio position would be $15,400 and will trigger a sell of 100 shares to drop us down to 600 shares and $13,200. Then with those 600 shares, if the stock further increases to $25 per share and a $15,000 portfolio position, we would sell an additional 100 shares to get down to $12,500 with 500 shares. Then if the stock reversed and dropped to $21, the portfolio position would drop to $10,500 which is within the range so we do nothing. If it drops further to $19 per share and $9,500 for the portfolio value, we would repurchase 100 shares to bring the portfolio position back up to $11,400.
Note, that in both of these scenarios, we are forced to sell at a higher price and buy at a lower price! However, there is a weakness in this strategy. You must monitor the investment to ensure the investment remains worthy. If I was trying to bookend Enron in 2001, I would be buying stock like crazy as it was crashing towards bankruptcy!
Like all strategies, bookend portfolios take discipline and effort to pull off. Then again, so does investing. If you are willing to put in time and effort, you can grow your assets and protect your future! Whether or not you beat the market is up to your skill, your efforts, and plain old luck. Many people give up trying to beat the market and simply invest in index funds. There’s nothing wrong with that! Especially if that is as much time as you can devote to investing. So far, I generally have done a little better than the market, but I don’t know if I will be able to keep that up. All I can do is keep trying. Good luck to you in your planning!