How to Sell a Stock

Fundamental analysts would suggest selling a stock when the company's prospects begin to deteriorate. When the CFO quits, or the new, whiz-bang product fizzles, or if earnings miss expectations, investors should eliminate the holding from their portfolios. It's a traditional, quaint and money-losing approach.

A company and its stock are two different things. Because it's the stock that you trade, the company's performance should be the least influential part of your decision-making process. It's the stock — and, more specifically, the stock's position in your portfolio — that should drive the decision-making process.

Also, as we often point out, fundamental news tends to trail price action, not precede it. This is precisely why investing is called speculation. Once the news is out, it's usually too late for investors to capitalize on it.

So when do you kick an investment to the curb? One time to consider selling is on those few occasions when an investment has grown to become a dominant part of your portfolio — say 10% to 15% percent. However, even at that point, I don't advocate indiscriminately dumping shares. I'd stagger some stop-loss orders — predetermined levels below a stock's current price at which the stock is automatically sold — below the market price. With XYZ at $50, for example, I might opt to sell a third of the position at $46.31 and another third at $43.31. This approach allows me to reduce my risk if the stock weakens, yet remain in the trade should the bullish trend continue.

Of course, such an embarrassment of riches isn't a frequent occurrence. When it comes to selling an investment, you should be more familiar with tossing the losers than the winners.

Thanks to Martha Stewart, most investors have learned about setting stops. Some people use a percentage decline; others use a particular technical indicator. What matters isn't the particular strategy you use, but that you use a strategy in the first place. No matter how "risky" or "safe" an investment may be, an experienced trader always predetermines and limits potential losses.

Once a position has become legitimately profitable, by a minimum of 10%, the next goal is to make sure that profit doesn't turn into a loss. The most natural stop order should rest one "round turn" (the cost of two commissions) above your entry price — essentially at a level that would net a breakeven on the overall trade. As a result of my discipline, I'd estimate that as many as 50% of my total trades end up being scratches. While the profits from a winning trade evaporate, the trade itself — the initial capital investment — never becomes an outright loss.

For most investors, the prospect of missing a chance to grab profits isn't easy to swallow. It's my belief, however, that the profit itself isn't as valuable as the winning position. The most powerful, highly probable place to be in the market is to hold an open winning trade. At any given moment, it's the one asset the vast majority of players don't have. Most people hold their losers. Over time, that's a doomed approach.

Every loss hurts. But there's something about watching a profit turn into a loss that's especially painful. All traders deal with the continually haunting echo of "coulda, shoulda, woulda." But the emotional debilitation of watching a 20% winner turn into a 20% loser will throw off even the most disciplined hand. Unfortunately, it's a lot easier to say "let it ride" once you're down on the trade and are desperate to believe that shares are simply "oversold." That's rarely the case.

But, of course, you should stop a 20% or 30% loss. There's no more sense in holding onto XYZ after a 35% decline just because you used to own it at a 25% win.

Case in point: Just take a look at how many portfolios still hold Microsoft (MSFT), Lucent Technologies (LU), Time Warner (TWX) and Sun Microsystems (SUNW) — all the washed up growth stocks from the 1995-2000 bull market. While virtually no investors have made money in these stocks in years, they are still in plenty of portfolios, no doubt in part because we remember buying them at such comparatively high prices. They were winning stocks once — so the belief is that they'll be winning stocks again. And maybe they will be eventually. But traders must focus on the here and now. In order for Sun Microsystems to regain its 2000 high, the stock has to gain more than 1,500%. It might happen, but probably not in my lifetime.

Another nuance I've added to my sell technique over the years is to add a time-stop element to profitable trades. Essentially, I tweak my breakeven stop based on the length of time I've held the trade, relative to a cash-equivalent benchmark. The longer I hold a trade, the less I'm willing to let a profit slip away.

For example, say I've held XYZ for two years, over which time the stock is up 20%. Estimating the risk-free rate at averaging about 3% over the last two years, the absolute latest I'd be out of the trade would be at 6% above my purchase price. This approach ensures that, although I might lose much of a profit on the trade, the return will still end up at least matching the risk-free rate I would have made sitting on the sidelines.

Naturally, your stops get tighter as time moves along. And although you might not necessarily sell the investment, each year that goes by you quietly move another few dollars into the profit pile.

Not only does this protect a gain, but it also helps to keep capital focused on timely trades. If you've held a stock for five years that hasn't moved significantly beyond your purchase price (or stopped you out along the way), you have to begin to question if the original analysis was correct. This trick keeps returns pegged to at least the risk-free rate, and helps to keep capital from going stale in trendless, go-nowhere trades.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.