When should you sell?

I recently received an e-mail from a newsletter subscriber who asked: “What parameters do you utilize when you decide to sell? I wish to enhance my learning experience.” It’s an excellent question. Typically, investors spend hours or even days agonizing over whether to purchase a security. But they give very little thought as to when to sell it.

This isn’t surprising because while it’s easy to obtain professional advice on when to buy, you’ll rarely hear a sell recommendation from an advisor and virtually never from an analyst. In fact, if you have an advisor who occasionally suggests that you exit a security be thankful. As long as there isn’t churning going on, it means he or she is paying attention to your account.

You rarely see a research report with the word Sell emblazoned across the top. You have to look for clues. For example, when RBC Capital Markets puts an “Underperform” rating on a stock, I interpret that as a signal to get out. At CIBC World Markets, the code term is “Sector Underperformer”. Another frequently used code word is “Underweight”.

Without guidance, how do you decide when to pull the trigger on a sale? Here are my personal inditors.

Sell when you reach a target price. When you buy a stock, be sure to set upside and downside targets. When the shares reach either target, do a complete review as if you were deciding for the first time whether to buy.

If the shares have reached your original upside target and you would still buy them, set new targets both on the upside and the downside. When you do this, you have the option of selling part of the position and moving your downside target to the original purchase price. That way, you guarantee yourself a profit no matter when happens later.

If the downside target is reached, take the loss and move on. This is where many investors run aground. They can’t bring themselves to sell so they hang on in hopes of a recovery. Too often, it never comes.

Sell if there is a change in the economic climate that works against the stock. Certain types of stocks perform better when the economy is strong and interest rates are rising. Others do well in slow-growth, low-rate environments. When you buy shares, find out whether the company is especially vulnerable to changes in the cycle. Right now, for example, we are seeing record oil prices. This is bullish for energy companies but bad news for airlines, transportation companies, automobile manufacturers, etc.

Sell if the stock is threatened with political action. Pharmaceutical stocks have come under tremendous pressure in the past couple of years for two reasons, both politically related. One is the on-going controversy over high U.S. drug prices and the import of cheaper products from Canada. There is concern that the American Congress will move to legalize those imports or take steps to bring domestic prices down. Either action would cut profit margins for the big U.S. drug manufacturers.

The second worry is the recall of some big-name drugs like Vioxx and warnings about potential dangers from others. Here again, investors are concerned about tougher government regulations that could have a negative impact on the pharmaceutical sector. No wonder the stocks have been laggards.

Sell on unexpected and serious bad news. We never recommended Atlas Cold Storage Income Trust in any of our newsletters but I personally owned some shares in one of my portfolios. When the news broke in fall 2003 that the trust was suspending distributions, terminating their CFO, and appointing a special committee to investigate the books, I sold my entire position immediately. After that, the news got progressively worse and the value of the shares plummeted by more than 50 per cent.

There was a time when a sell-off on bad news was a signal to buy as the stock would almost certainly rebound, often sooner rather than later. But things are different now. We have seen too many cases in which bad news simply begets more bad news, especially if there is any suggestion of corporate malfeasance, and the share price continues to spiral down. If it should happen to you, the best course is to get out with minimal losses while you can.

Sell when a stock’s market value exceeds 10 per cent of your portfolio. Sometimes we get lucky and a stock that we own explodes in price. If you’re the beneficiary of such good news, that’s terrific! But take a look at your portfolio and see how much the high-flyer represents in terms of its total value. A big gain in a short time may have pushed the stock’s weighting over the 10 per cent mark. That’s too much to have tied up in a single asset, no matter how well it has done. Proper diversification is one of the key strategies in risk reduction. So sell some of that big gainer to reduce the weighting to below 10 per cent. Spread the money around; there are always other opportunities.

Of course, before you sell anything in a non-registered portfolio you should consider the tax consequences. If you have to take a loss, make sure you have some capital gains against which to deduct them, either from this year or previous years. If you’re going to take big profits and have no losses available (lucky you!) be sure to keep some of the proceeds in reserve in order to satisfy the demands of the Canada Revenue Agency when it comes time to file your next return.