Before Holding, Ask Yourself 7 Questions

2/22/2010


If I had to do the last 15 years all over again, I’d be quicker to sell my problem stocks. That would certainly be true for the crash of 2008. But even in better times my inclination to stand pat has cost me, often because deadwood kept better names out of my portfolio.

Selling stocks is hard. It’s hard emotionally, since it requires admitting a mistake. It’s hard professionally, as complaints that I downgrade stocks too quickly and that I stick with laggards too long are among those I hear most frequently. And it’s hard objectively, partly because most of us are most inclined to sell when others are exiting on bad news — and partly because selling on such disappointments is sometimes exactly the right thing to do.

While I am almost certain to get more lessons the hard way in coming years, I have learned a few things about selling in the roughly 15 years I’ve been running this newsletter. So, before you decide to continue owning any stock, I suggest you consider the following questions:

Would you buy it today? If a stock is not a buy, it is a sell. Many object to this maxim on a gut level. But, ultimately, the only differences between buying a stock and holding a stock are trading commissions and taxes. Trading commissions have plummeted over the past 15 years, and tax considerations typically favor selling losers quickly. So, unless a stock is one of your favorites — or you have a big taxable gain you want to defer — you will typically be better off selling and moving into a name you truly like.

Is the reason you bought the stock still valid? This may seem like a repeat of the first question, but humans have a hard-wired tendency to seek affirmation of past decisions. We’ll use growth projections to justify holding a winner that was purchased based on its valuation, or we’ll justify holding a losing growth pick because it has become cheap. Be wary of such rationalizations; they are the path to mediocrity.


“Ultimately, the only differences
between buying a stock and
holding a stock are
trading commissions and taxes.”


Is a better stock available? The best way to maximize returns is to limit your portfolio to your best ideas, and you will never know if your current holdings qualify unless you compare them to other stocks. By looking for new stocks and maintaining constant competition for space in your portfolio, you’ll improve your chances of exiting second-rate names before they hurt you.

How will you feel if the stock slumps 5% over the next few days? Will you be kicking yourself for not getting out at higher prices? Or will you be looking to buy? If you anticipate kicking yourself, you should probably sell now. Stocks can move 5% on little or no news, so if such a minor drop is enough to trigger remorse, the stock is probably not one of your favorites.

Are you worried about your winning percentage? Because most investors dislike taking losses, many tend to hold losers too long (in hopes of seeing a rebound) and sell winners too quickly (in order to lock up gains). Such behavior is self-defeating, for it is the magnitude of success (not the frequency) that drives portfolio returns. Except for taxes, the purchase prices of the stocks you own are not particularly important. Don’t worry about getting back to break-even on a particular stock; focus on whether a stock represents one of your best ideas for gains from current prices.

Are you worried about looking stupid? Selling a stock right before it rallies is among the most frustrating things for an investor. But you should not let fear of potential remorse keep you in a stock that no longer ranks among your favorites. For example, if you have good reason to think a pending earnings release or other news development will mean bad news for a stock, you should sell it now. You may occasionally get it wrong and see the stock surge on better-than-expected news, but you will also avoid some sell-offs. Selling prematurely may result in opportunity costs, but selling belatedly will result in actual losses.

How liquid is the stock? For stocks with small market capitalizations and low average trading volumes, trying to sell on good news is especially important. If you wait to sell such illiquid stocks on disappointing news, you may be crushed in the rush to the exits.

LIST RETURNS AND TURNOVER NUMBERS

The bad news: We’ve made some mistakes in recent years, holding on to some stocks too long and selling others too quickly.

The good news: Perfectly timing sells and buys is not necessary for strong returns. Consider the numbers below, which show fully invested returns for our Focus List, Buy List, and Long-Term Buy List since 2003, excluding dividends and transaction costs.

For a long-term perspective, consider the returns calculated for Dow Theory Forecasts through year-end 2009 by the Hulbert Financial Digest, an independent watcher of investment newsletters. According to Hulbert, the Focus List, Buy List, and Long-Term Buy List have all outperformed the market since their inception dates — both on an absolute and risk-adjusted basis.

For Dow Theory Forecasts overall, Hulbert reports that we are among a select group of newsletters that has outperformed the market over the past one, five, 10, and 15 years. The Forecasts has outperformed despite below-average monthly volatility, meaning our outperformance is even greater on a risk-adjusted basis. Over the past 10 years, a relatively tough time for stocks, the Forecasts has outperformed the S&P 500 Index by 4.8% per year on annualized basis.

—–— Focus List –——
——— Buy List ———
– Long-Term Buy List –
S&P
500
Index
(%)
Year
List
Change
(%)
Adds
Drops
List
Change
(%)
Adds
Drops
List
Change
(%)
Adds
Drops
2003
20.2
13
12
25.0
13
16
24.0
10
14
26.4
2004
17.5
7
7
18.8
10
9
8.7
6
12
9.0
2005
8.1
7
8
10.3
15
15
3.5
8
10
3.0
2006
12.9
8
10
14.8
15
12
9.3
11
11
13.6
2007
22.8
9
8
18.1
17
21
10.4
10
16
3.5
2008
(48.8)
9
13
(44.7)
13
19
(36.4)
12
18
(38.5)
2009
40.3
10
8
35.7
15
14
28.5
13
11
23.5
2010 †
(0.1)
2
1
(0.6)
2
2
(1.4)
2
2
(1.8)
Since 2003 † 
51.6
65
67
65.7
100
108
35.5
72
94
24.4
† Through Feb. 16.
Notes: Returns are fully invested and  exclude dividends and transaction costs.

 


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