How to Know When to Exit a Position

July 26, 2016 |

Knowing when to sell is one of the most challenging aspects of investing. To improve your performance, you can analyze charts to understand when it would have made sense to sell a stock in the past. Of course, “hindsight is 20/20” while reading the current moment is never as clear, and it can be fraught with emotion.

In this article I want to explore why knowing when to sell can be so challenging, and provide practical tips for approaching the question. For more discussion and a live demonstration, watch my When to Sell webinar from earlier this year.

The Emotional

Deciding when to exit I find to be the hardest thing to do as an investor. Why?

It is a much more emotional decision than buying. You have already made the decision to commit to this stock and have formed some sort of bond with it. So selling it is a bit like departing with a loyal friend.

If it has treated you well, you feel disloyal. And you feel if it has done well in the past, why can’t it continue to do well in the future? After all it has momentum on its side, which is Newton’s first law of motion. Also you will faces two other issues: generating a guaranteed tax bill and finding a better replacement (which means work on your part).

If it has treated you poorly, you may secretly feel that it is only a question of time before the market recognizes its virtues and you should wait it out. On the other hand, if you clearly see that things have really changed, or if you missed a key fact in your investment analysis (like the company has too much debt), you know in your heart it is time to go. But you feel loss. Selling will be the acknowledgment of the mistake, and is also the abandonment of hope. It makes you feel stupid—why didn’t I just set fire to my money?

In fact, the field of behavioral finance has demonstrated that the pain we derive from market losses impacts us twice as much as the pleasure we feel from market gains.

And there is the other big fear: you sell and the stock rallies right after. There is no worse feeling in investing. You are left behind while everyone else has a good time and you feel even stupider. I’ve been there, it doesn’t feel great.

So, the emotional component of ownership makes selling a much tougher decision than buying. The “endowment effect” is a well-observed phenomenon in which people tend to overvalue things they already own. For example, when people sell their houses, they invariably think their house is worth way more than the realtors do, who try to talk the client down to a realistic selling price. Unfortunately the same holds true for stock ownership.

The Practical

The best place to start is to ask yourself the following question and answer it honestly:

“If I didn’t own the stock, would I buy it today?”

If the answer is no, you should probably sell. One exception would be you have a huge gain and think the stock is not great, but is “okay.”

If you are really unsure, you can always sell a portion of your position to hedge your own judgment a bit.

Factors

Here are some factors that can help you decide if and when to sell.

Valuation

  • Current P/E versus historical—if the stock is breaking into new P/E highs, it could be overextended.
  • When the rise in the stock is solely due to P/E expansion (i.e. the price is inflating while earnings stay the same), you may want to reduce or get out. See below.

valuation

Technicals

  • When the simple moving average (SMA) changes that show the stock is losing momentum. See the weakening SMA 150 with a SMA 50 crossover below.

sma

  • Sector or industry rotation—the sector or industry is getting more “out of favor.” Such negative momentum is on display in the following two charts, both compared to the S&P 500 (in red and set as a baseline).

sector momentum

industry momentum

  • Chronic underperformance—it’s tough to make money when your stock is in a bad neighborhood:

weak sector

  • Decreasing earnings estimates, which can be found under the Analysts tab of the Insight panel. The image below shows that the estimates have been revised downward a few times, so they are lower than they were 90 days ago.

estimates

  • Extended chart (the price is way over its averages), as illustrated in the next two images. Notice the sale should come on the first jump. You may miss some more top, but in the long run you will be happier by avoiding big drops.

extended chart

extended chart

More Factors

A few more things to consider when deciding if to trade…

  • In a down market, is your stock, industry and sector underperforming badly? If so, consider selling.
  • Change in business outlook. The company’s profitability may be affected by things like…
  • Decreasing demand for a core product
  • Oversupply (for example, in the energy sector)
  • Commodity prices
  • Other macro factors (interest rates, currency exchange rate, Brexit, etc.)
  • Negative news. Is the company getting bad press that is exacerbating real fears?
  • Management changes. You liked the old team, do you like the new one?
  • High hedge fund ownership—this can get ugly if the hedge funds pull out.

Summary

You can practice some of these concepts by looking at different ticker charts to see when would have been a good time to get out in the past (try to remove the benefit of hindsight!). Charting in Stock Rover is pretty straightforward, and you can always reference our charting help if you have questions about how to replicate something you saw in this article.

Remember that selling is not easy, for anyone. Just try to put on a rational hat, look at all this stuff covered in this article, and then ask yourself that critical question “If I didn’t own the stock, would I buy it now?”

If the answer is anything but yes, start re-thinking your position.





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