Just as important as buying...
INVESTORS spend a lot of time thinking about buying shares, writes MoneyWeek editor John Stepek.
But they should consider their selling strategy too.
When it comes to investing in shares, there's plenty of advice on how to identify companies to buy. But there's a relative dearth of advice on the other big transaction involved in successful investing – knowing when it's time to sell.
As Miles Johnson noted in the Financial Times recently, this is a pity, because selling too early can be as bad, if not worse, than selling too late. As Johnson notes, even the likes of Warren Buffett are not immune.
In 1966, Buffet paid $4m for 5% of film studio Disney, then sold a year later for $6m. That 50% profit looked good at the time. Now it looks like a very costly mistake – Disney is worth around $170bn, and that's before you consider any dividends paid out.
So how do you decide whether or not to sell?
I like to keep things simple, so I'd argue that there are just two reasons to sell a share (other than the fact that you have achieved your financial goal, and now want to spend the money). Both of these, however, depend on having a sensible buying process in place.
When you buy a company, you should record your reasoning in a spreadsheet or a journal, so that you always have that to refer to (the mind will play tricks on you otherwise). And your overall portfolio of individual shares should hold a spread of companies across a range of different business sectors.
As long as that's the case, then roughly 20 shares – give or take – will give you the benefits of diversification without overly diluting performance.
So why should you sell? Firstly, sell if there is a fundamental deterioration in the prospects of the business. If something happens (signs of fraud, say, or a major profit warning) to disprove your investment case – which you wrote down when you bought the share, remember? – then act.
If you can't honestly say that you'd still buy today, given what you know now, then you should sell your holding entirely, and find a better opportunity. This will help you to think about what to do in situations where things have gone badly wrong.
But what of situations where everything is going right, and your main concern is that the share is getting too expensive, and you might give away profits if you hold for too long? The problem at this stage is that you might end up selling what turns out to be a Disney, rather than a momentum-driven flash in the pan.
So I'd rely on that old faithful, rebalancing. If a specific holding goes up so much that it accounts for more than a certain percentage of your portfolio, take profits to reduce its allocation.
You will miss out on future potential profits, but it will also shield you from regret-driven errors (either caused by holding on too long, and so seeing your paper profits evaporate; or selling too soon, thus missing out on potential gains).