Deciding when to sell requires disciplined mindset

Investors generally dislike the comparison between gambling and investing, but sometimes there are similarities and lessons to learn.

Annie Duke, a former professional gambler, wrote a book titled “Quit: The Power of Knowing When to Walk Away,” in which she explains why quitting is integral to success, as well as “strategies for determining when to hold ’em, and when to fold ’em.”

If you watch professional poker players, you will notice that about 85% of the time they fold immediately. Professionals can readily recognize hands that are likely to lose, while most amateurs are more likely to continue to the next round. Duke argues that many factors work against people who are considering quitting, often pushing them to act irrationally.

Behavioral science can shed light on why it’s harder to exit a stock position. Loss aversion is one bias. That’s the rule that people hate losses more than they enjoy the equivalent gains. Another bias is the endowment effect, in which individuals value things they already own. Knowing you have a paper loss and need to turn it into an actual loss (loss aversion) while at the same time letting go of an asset you value (endowment effect) makes closing a losing position difficult.

Alex Imas, a professor at the University of Chicago, studied the behavior of retail investors who set take-gain and stop-loss orders when they entered a trade. (A take-gain order will automatically sell your position once you’ve hit a predetermined profit. If your investment loses value, you can minimize the cost with a stop-loss order to sell at a predetermined point.)

While these strategies are designed to counteract harmful biases, Imas found that few investors allowed their stock position to reach their full take-gain orders. Instead, they sold manually rather than risk losing their gains.

On the other side of the trade, investors tended to cancel their stop-losses, preferring to keep gambling that the price will reverse rather than taking a certain loss. He found that professional fund managers are disciplined on the buy side but are less disciplined on the sell side. They use simple rules of thumb, disproportionately selecting positions where relative performance had been very bad or good, and exited those.

Knowing when to sell an investment is just as important as knowing when to buy. Investors keep watch lists of assets they are interested in buying, but little thought is given to the sell side.

Best practice for investors is to develop an exit strategy with each stock purchase. There can be several good reasons to sell, including locking in profits at the right time or stemming losses before they grow too large. It is important to monitor both fundamental and technical indicators, such as a stock price target. Keeping an eye on corporate actions, and news is key to timing an exit.

Additional times when it can be beneficial to sell a stock include changes in these company fundamentals:

◗ Deteriorating financial performance: Look for declining sales, shrinking profit margins, increasing debt or poor earnings compared to industry peers.

◗ Weakened competitive edge: The company is facing increased competition, struggles to innovate or becomes obsolete due to technological advances.

◗ Poor management or governance issues: Unethical practices, poor leadership or decisions prioritizing management over investors are red flags.

Be vigilant during company mergers. If an investor is lucky enough to own a stock that ends up being acquired for a significant premium, it would be a good time to sell. Corporate mergers have a lousy track record. Mergers take a long time to complete, and there might be better upside potential owning a different stock.

Pay close attention to company bankruptcy. And for tax purposes, there is potential value in selling your investment at a loss or establishing worthlessness. The loss can be used to offset future capital gains taxes for selling another investment at a profit.

The right time to sell depends on your investment goals, financial needs and market conditions. If a stock has reached your target price, its fundamentals have weakened, your portfolio needs rebalancing or you need to generate cash, selling might be a smart move.•