Monday, January 24, 2005

When Does One Sell?

‘You hold on to stocks like they’re your babies and then sell when they are at their lowest!’ says my wife, making a point. Sound familiar?

A lot’s happened in the past month – the stock market bull run turned into a bit of a dream run, with stocks rising to dizzying heights. We saw record highs that even a year back few would have predicted. And I saw my investments generate over 50% in unrealized returns – man was I good!!

The key word in the fairy tale above of course is ‘unrealized’ returns – that's about the only realization I've had in the past month. It’s been only a few weeks since the record highs and the market index has fallen by around 10% or so, wiping out a lot of those gains. Stocks that had gotten ahead of their valuations have returned to more reasonable levels (though not to bargain prices by any stretch of imagination). Thankfully, I’m still profitable, though of course at a more modest level.

But why, oh why, didn’t I sell?

Kind of makes one wonder, doesn't it? Is a buy-and-hold strategy really a good idea? And if it is, how long should one hold? And when should one sell?

Is a Buy-and-Hold Strategy a Good Idea?

I think it is, at least for me. Look at the benefits – lower tax, less worry and no need to time the market except in a broad sense. On the down side, one tends to fall in love with one’s buys and live in a world of paper profits and ‘unrealized’ gains as I’ve just figured out. That, however, needs a mind-set change and acceptance of selling as an important aspect of investing. A bit of discipline (and a sharp jolt like the current downslide) should help sort it out. Not a problem, really.

When Should One Sell?

As with the choice of investment approach, there seems to be no single ‘best’ method for determining the selling strategy. Here are three options that have stuck in my mind and may be used as appropriate:

  • In a rising market, set stop-losses at levels below the normal stock price fluctuation so they get triggered in case of unusual dips in the price. This has the advantage of being a mechanical method and hence creates discipline. The downside of course is that the stop-loss levels should be reviewed periodically (perhaps even daily) to ensure that they are relevant to the current stock price. Further, this approach will also lead to short-term corrections inadvertently triggering off the sale of a stock that should actually have been held for longer
  • Peter Lynch’s investing approach is to find companies whose stocks have a good reason to grow manifold in the near future and then wait for the market to catch on. Hence the selling strategy would be to do so once the story has been fully played out, as per the investor’s opinion. The advantage of this approach is that it looks at the long term potential rather than at short-term price movements. The disadvantage of course is that the investor might be wrong in his / her assessment of the company or that the market may not bid the stock up in the near future. In the meantime the investor would hold on, accumulating losses in the hope of a turnaround.
  • Another approach is to sell the stock when it reaches a price such that reinvesting the proceeds in a low-risk investment would still allow the investor to meet his / her financial goals. This is actually an intriguing idea – I think this is Warren Buffet’s - and it’s worth dwelling on this further.

Sell High and Re-Invest in Low-Risk Instruments

Let’s say you have invested Rs. 1,000 today in the hope of turning it into Rs. 10,000 in 10 years (you’re target returns are 25% compounded per annum). Now suppose after two years there is a major bull run and the stock reaches Rs. 5,000. Based on this philosophy, the investor could sell it and invest the proceeds (Rs. 5,000) into a low-risk bond at 8% let’s say. At the end of 10 years, the investor would have made approximately Rs. 9,500 with almost negligible risk.

This way, the investor meets his goals in the most efficient way by taking advantage of a bull run to jump-start the process. A capital idea (again no pun intended!), but would one be able to do this? Would it not take fabulous amounts of forbearance to sell a stock that’s doing well and put it into the boring ‘slow and steady’ bond that will get you to your goals but will not help you get rich quick? Would it not cause pangs of regret when the same stock scales even greater heights immediately after you sell? And what if it hits Rs. 10,000 when you’ve sold at 5,000 to take the scenic route to your destination? Whoa, that’s a killer!!

And do I hear you ask what I would do? I’d go for the rational and disciplined approach of selling high and investing in bonds, of course.

Or perhaps leave just a wee little bit in the stock just in case…

Actually, let me just wait till the next bull-run to find out.