A couple weeks ago, I got a little bit of money together and bought some stocks. Markets are a bit lower than a year ago, so it’s pretty hard to go wrong. Knowing which stocks to buy isn’t easy, but it’s not rocket science either. In the past, I’ve invested for value, for income and for momentum. I’ve had both good and bad luck and I’ve made both good and bad decisions. As an aside, my worst decision was “catching a falling knife.” Based on my experience and my understanding, my strategy is mainly a value approach, leaning toward GARP.

Now that I own stocks, I’m faced with new questions, to which I was insufficiently attentive before. Was I right or wrong to buy them? How can I tell if I was wrong? Right or wrong, when do I sell? The sell decision has just as much impact on long-term success as the buy decision, but less attention is paid to getting it right (70 per cent of the companies polled were not approaching the selling of stocks in a “highly disciplined” manner). Most investment managers articulate one or more of these three approaches to the sell decision: “when a price target is hit, an investment thesis has changed, or when a more desirable investment is found.”

Setting a target price for a stock at the time of purchase is a good idea. It helps an investor to quantify their expectation for a stock investment. Further, it gives a benchmark to evaluate stock performance over time. It doesn’t necessarily force the investor to sell the stock when the target is reached, but it provides a hint that the stock research should be re-done. This is an optimistic approach that answers the question: Was I right? When a stock reaches a target, I was right. Based on research, I can then either set a new target, take profit or sell the position.

The other two approaches, a change that affects the investment thesis and finding a more desirable investment, begin to address the cases where I was wrong. But I notice that both approaches skirt the possibility of making a mistake, and blame the problem on external factors: something in the environment has changed or it’s only performing poorly by comparison to others. (Avoiding responsibility is a subconscious human reaction.) But it also underlines the fact that it’s very hard to determine if a decision was right or wrong, especially based on a stock price that fluctuates by the second.

My preferred approach is based on program evaluation. It starts by asking: What is the purpose of the (investment) program? Possible answers may include: market-based return, beating the market, income, safety, meeting financial planning targets or being part of the next big thing. Next, each stock that goes into the portfolio should have a purpose, e.g. income, capital growth, diversification or speculation. Each should also have an evaluation criteria, e.g. income level, target price, volatility. Once a stock has been chosen and its purpose and evaluation criteria set, it is added to the portfolio. The buy portion is complete.

The sell portion begins after the purchase is made. I will suggest that the portfolio and each of its holdings should be evaluated somewhere between monthly and quarterly. Compare each stock against its criteria, based on its purpose in the portfolio. Is it meeting its objective, missing, or falling far short? Has anything changed?  If the stock is performing to expectations, no action is required, although targets may be updated. If it is exceeding expectations, the manager will have to decide between adding to the position (greater potential) and trimming the position (greater safety). If it is missing targets, the manager will have to decide between adding to the position (greater risk and potential) and cutting losses. If the stock is falling far short, it is probably best to admit a mistake and close the position, freeing up the capital for a better opportunity.

Setting a target price or income level makes sense over a long period of time, but evaluating progress quarterly will probably most make sense in comparison to the market. If the price of my stock is down, further from its target, but less than the market, I will assume that’s good news since it has performed better than expected, given prevailing headwinds.

The decision to sell is not an easy one. There is no clear signal that the best profit has already been earned or that the purchase was a mistake. But this reliance on judgement is what makes investment management so interesting.


Sell Discipline

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