Personally, I think the toughest part of the investing process isn't analyzing companies or valuing stocks - it's figuring out when to sell the stocks I own.
Judging by the e-mail I receive, a lot of other investors seem to feel the same way. For instance, Joe McElroy writes, "I wonder about throwing out the rotten eggs, of which I have a bunch. ... I bought some stocks when they were well off their highs, but they kept dropping lower. But why should I sell these rotten eggs at steep discounts? Some people would say I should cash out these losers and get into something else, but there's no promise that the 'something else' won't tank as well. ... If I dump my rotten eggs I will have bought high and sold low."
Mr. McElroy's got a point that buying high and selling low is not the route to investing success. On the other hand, knowing when to cut your losses and move on is a critical part of portfolio management. You can do pretty well as an investor by simply avoiding big losses.
As fund manager Bob Olstein said in an interview last fall, "In this business, the good performers are the ones who make the fewest errors, not the people who hit the most home runs. You win by making the fewest mistakes."
So, let's start with bad reasons to sell. There are a lot of these, but I think the following three are the most prevalent.
By themselves, share-price movements convey no useful information, especially since prices can move in all sorts of directions in the short term for completely unfathomable reasons. Moreover, the future performance of stocks is largely based on the expected future cash flows of the companies attached to them - it has very little to do with what the stock did over the past week or month. So when you're making a sell decision, look to the future, rather than the past.
It is so, so tempting to use the past performance of stocks in your portfolio to decide which to sell and which to keep. But remember: It matters little how those stocks have done in the past - what's important is how you expect the company to do in the future. There's no reason why stocks that are up a lot should drop, just as there's no reason why stocks that have tanked "have to come back eventually."
The trick is to stay focused on the future. Let's say I buy shares of a retailer that was having some major liquidity troubles but that was so cheap that its real estate alone was worth more than the enterprise value of the company. I also buy a former tech darling that's fallen on hard times but that I think can tough things out until technology spending improves. Six months go by, and the retailer has doubled, while the tech firm has fallen 30 percent. I should lock in my gains on the retailer, and hang on to the tech company until it turns around, right?
Wrong. The stock price movements say nothing about the health of the two businesses. Over the past six months, my hypothetical retailer has sold off some stores and made big improvements to the way it manages inventory, so the liquidity crisis is past. Moreover, same-store sales numbers are faring well, profitability is on the mend, and the stock trades at about 14 times earnings. Sounds like this one's worth hanging onto. Meanwhile, the tech company has struggled as a large competitor has initiated a brutal pricing war, a rebound in corporate information technology spending looks even farther away, and a couple of senior managers have bailed out. Hmm - might be time to cut my losses on this one if things look that much worse than when I initially bought the shares.
One of the silliest things I hear people say is, "I'll sell that dog when it gets back to break-even." The only thing that matters is your estimation of a stock's performance vs. alternative investments. If you own a stock that's down 20 percent with very poor future prospects, and there are better investment opportunities out there, you're better off booking the loss and putting the proceeds in the other investment than stubbornly hanging on. Cumulative investment returns of 0 percent - minus transaction costs - aren't terribly attractive, after all.
Pat Dorsey is an analyst for investment research firm Morningstar.