Imagine this simple scenario…
Say you own two stocks. You bought each at $50 a share. Over the course of your investment, one has risen to $75 per share. The other has fallen to $25.
Suddenly, you need to raise money. Perhaps a car you’ve wanted is on sale at the local dealer or a cabin on a lake where you want to retire is suddenly on the market. You need to raise some cash. You decide to sell one of your investments.[ad#Google Adsense 336×280-IA]But which stock do you sell?
If you’re like most people, you choose to “capture” your gains… sell the $75 winner and keep holding the $25 loser.
You may think the loser stock seems to have more upside potential, and you’ve probably been waiting to “get even” on the position…
It’s a nearly universal impulse… but it’s a terrible investing choice.
We love to sell our winners too soon and ride our losers too long.
A slew of behavioral finance studies show it. One, by University of California at Berkeley professor Terry Odean, found investors are almost twice as likely (1.7 times) to sell a winning stock as they are to sell a losing stock.
Following similar logic (urges, really), investors held losing stocks for 124 days and unloaded their winning stocks after 102 days.
But you may wonder, “Maybe the winning stock had grown overvalued and its gains were behind it.”
It turns out, the winning stocks (which had been sold) subsequently outperformed the losing stocks (which investors were still holding).
It depends on what time frame you look at, but the general consensus is that over six- to eight-month periods, stocks that are moving up tend to keep moving up, and stocks that are falling keep falling. It’s a phenomenon called “autocorrelation.”
This confirms the old adage: “Let your winners run and cut your losers short.”
OK… But how do you know when to cut your losers… and when your winners have had enough time to run? In other words, how do you know when to sell your stock?
There’s no single rule that will tell you when to sell… because there’s no rule that tells you when to buy.
The strategy for selling is determined by why you bought in the first place – and should be determined at the time of your initial investment. It’s critical when you buy to know exactly what you expect to get out of the investment and what would lead you to sell…
So when I buy stocks, I do three things:
1. I write down WHY I bought it.
2. I write down WHEN I’ll sell it.
3. I review my investment at least once a year (but preferably every six months).
One trick I use when I’m deciding whether to sell a stock is to ask myself whether I’d buy more right now or recommend it to friends or family members. If the answer is no, it’s probably time to sell.
And in my Retirement Millionaire newsletter, I recommend 25% trailing stops with our stock investments… We sell if the stock falls that far from its high point during our holding period. Trailing stops are a simple, easy-to-understand way to eliminate your emotions and get out of losing positions before they get too large.
If I’m really worried that I’m making a mistake selling a stock… I remind myself that I can always open a new position after a 30- or 60-day break. There’s nothing magical about the time frame. It just serves as a cooling-off period for my emotions. Most likely, a good investment will still be attractive at that point. And in many cases, I’ve found better opportunities by then.
Yesterday, stocks hit all-time highs. And if you’re like most people, you’re starting to worry. You’re wondering if you should “take some money off the table.”
Before you let your emotions make the decision, consider whether you’re making the common mistake of “capturing” gains. And think about putting a better plan in place.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig[ad#stansberry-ps]