Selling

Now that you have complete all the work to find, review, and purchase a great opportunity, there will be a time when you will wonder when to sell. Knowing when to sell is much more difficult that determining when to buy, as there are a number of factors that need to be considered, that are not considerations when considering a buy.  Further still, is that when considering a buying opportunity, if something doesn’t look right, or there is a potential issue that cannot be satisfactorily understood or managed, the potential buyer can simply move on to something else.  When considering to sell, you have no choice but to make a determination as walking away is not an option.

Before considering selling, it is important to consider some significant reasons not to sell.  The first is that based on the investing strategy outlined, it will take time for many investments to work out.  Rushing to sell before the underlying investment thesis has had chance to be fully realized will curtail long run returns.  Having the patience to see things through is critical to success with investing.  Similarly, there is a solid sentiment with many great investors that you should let your winning selections continue to win.  This also requires patience in general.  There will be many times in your investing pursuits where you will get something right, and will get the return you were expecting.  However often you will be very wrong in the magnitude of the return that might be realized.  If you jump out of investments too quickly, you will lose the opportunity to make some of the largest returns you will ever encounter.  Some of the best investments go well, then continue to go well, and then continue to get even better.  Allowing your great investments the time for this to occur can be one of the best things you can do.

A possible rule of thumb to follow is that no matter what happens, you will not sell something for at least 3 years.  This does three things:

1. It will greatly assist you in remaining focused on the longer term;

2. It will prevent you from making impromptu reactions with your investments;

3. It will ensure you allow your investments the chance to play out.

All of these are great outcomes and this rule is generally going to be a great one to follow, particularly when you are very selective in your investments to begin with.

A key principle in managing the selling decision is to make sure you buy the right things to begin with.  All of the work up front before you buy helps with several things regarding selling.

1. You will fundamentally understand the business that you own, or according to the approach you will not have bought it.

2. You will know the key drivers and what to look out for, which will help you discern if any material changes at the business have taken place.

3. In the absence of a material change, if the stock price goes down, you will not be questioning your original decision, and potentially seeing an even better opportunity than when you made your initial buying decision.

4. Through the original focus on opportunities with large upside (and limited downside) you will avoid many edge cases where difficult to discern minute optimizations are key to getting the desired return, and instead larger effects that are simpler to observe and understand are likely to be the key drivers of return, making monitoring the investment and subsequent decision making much easier.

5. Short term volatility is unlikely to impact your thinking as you will be focused on the long run larger moves for the investment.

There are other advantages of ensuring you buy the right investments to begin with as well, however the key point is that ensuring you put effort into selecting the right opportunities to pursue in the beginning will greatly assist through eliminating many of the potential difficulties when making a sell decision.

With the reasons not to sell in mind, as well as the idea that you made great buying decisions in the first place, determining when to sell can remain quite challenging.  However one question to ask that may make selling a bit easier, while keeping in mind the reasons not to sell, is if you would buy this opportunity now.  If the answer is yes, then selling should really be a consideration.  If the answer is no, that can be a cue that selling should be considered.  Also note that if the answer is unclear or not obvious, that usually means there is no reason to sell, something we will return to shortly.  Remember that at this point you have completed a detailed review of the opportunity when you bought and you understand this investment well.  A possible approach can be to run through the buying checklist again on the investment and determine if you would still view the investment as favorably or understand how compelling the investment is at this time.  Doing so can provide insights that you may not otherwise weigh when you consider continuing to hold the investment.  If reviewing the current holding this way provides a significant would not-buy-reaction, that can be an indication it is time to sell.

When considering the merits of selling an investment, the general sentiment is similar to those related to buying.  In general, if there is not a screaming reason to sell, it is most likely better to continue to hold on to the investment.  You are mostly looking for the reverse incredibly obvious “bat over the head” moment that tells you something is way overvalued and there is no way it is worth that much.  You will have a good understanding of these moments because of your upfront work.  Short of those moments, letting things play out that might be slightly overvalued, will mostly likely work out well in the long run.  Often investments rise to their slight overvaluation, and sometimes investments are valued appropriately and it is difficult to see.  Keeping in mind an ideal tendency to let your investments work out and the reasons to hold on to winners, the only direct selling cues are when it is very obvious the stock price is significantly higher than the underlying value of the business suggests it should be.

A critical reason to sell an investment is when something has fundamentally changed about the investment that significantly affects the future prospects of the underlying business.  If you have done your review of the investment opportunity upfront, you will know the important factors driving the business.  If something unforeseen occurs that significantly affects those factors in a negative way that was not originally contemplated it may be time to sell.  Things do happen in business that cannot be foreseen, and when they occur should be responded to appropriately.  This will definitely happen with some investments over time and is part of investing in general as not all investments will work out.  This does not imply quick reactions and the ability to respond immediately to any all circumstances.  It does however mean that when the situation has changed, do not be afraid to take action and exit your position.  It might be at a loss, or it might be at a low or no gain.  That will happen some of the time, but it is better to avoid further loss based on the updated situation than it is to just rely on hope, and not rational decision making, to recover losses.  Some examples of a situation materially changing include new material information about management, new unforeseen material negative information about the industry or business, or new material legal or governmental intervention in the affairs of the underlying business.  A key emphasis is that the new information has to be material as negative things happen all the time in business that do not affect the long term trajectory of the business.  Due to your upfront review of the investment before buying you will have a great idea of what is material for the specific business, and will know it when you see it.  Note that if new negative information really isn’t material, other investors may still react to it as if it was, which may create buying opportunities so keep that in mind as well.

Related to a material change in the business, is the unlikely event that you realize there is something you fundamentally do not understand about the business.  This should be very rare, as you should not be buying things you do not understand, but you are also human and mistakes happen, so this situation is not an impossible occurrence.  If something transpires in a business which has a material effect on it, and that something is something you have trouble wrapping your mind around, it may be time to exit and move on to something else. First you should try to understand it, as learning is the fundamental activity in investing, and you may be able to figure it out.  Additionally, while you may not be able to completely understand it, you may be able to determine that it is not material to the company and is not relevant.  Likewise, if the magnitude of the impact of this item is small, it may be irrelevant.  However, if you can’t figure it out, it is material, and the impact looks to be quite significant it is probably time to exit the position.  In that case there was something wrong in your original review of the investment and therefore it is not an obviously great investment.  Note that while exiting when you don’t understand something that could be negative may be obvious, it also applies with something that could be positive.  If you really don’t understand whether material effects in a business are negative or positive, it is highly likely you will soon run into trouble making decisions about that business.  Overall, it is better to exit and move on in those circumstances.

There are reasons to sell investments that have nothing to do with the direct merits of the selling decision.  A solid reason to sell an investment even if there is no direct reason based on review and analysis is when you find an opportunity that is clearly better.  For example, if you believe an investment is about fairly valued or slightly overvalued, that on its own is not a reason to sell.  However, if you are ready to buy another investment that represents a great buying opportunity you may need to sell a current position to move into the new one.  This inevitably leads to selling the positions you have assessed as least compelling in favor of buying a position that is much more so.  This is something to be careful with, as it is easy to get focused on the next interesting thing when you haven’t given your initial investments time to work out.  It can also easily slip from decision making into short term thinking rather than a long term orientation, which will generally lead to lower long term returns.  The best guard against this is to adhere to the strategy of when to buy, as the reality is that great buying opportunities do not come around very often, so this will only come up when there is something exceptionally compelling.  Finally, also keep in mind that short term buying and selling into and out of position is tax inefficient which will also affect your long run returns.

Another reason to sell that is apart from the direct assessment to sell is if the funds are needed for something else.  Life does happen, and particularly for retail investors, from time to time the funds will be needed or desired for something in their personal lives.  This is perfectly fine, and in many cases where the motivation and desire to invest originates from.  For this, keep in mind successful investing requires a long term orientation and that funds allocated for investing should be planned to be allocated for many years.  There is unlikely to be a good reason to invest funds that you will require shortly, so selling investments for this reason should be a reasonably rare event.  So long as you maintain a long term mind set, the reasonable rare occasion where you sell to use funds for personal reasons is a perfect valid reason to sell.  Like in the case where you find better opportunities, what you sell at any given time will generally be the least compelling holding you have at that moment.

Keep in mind tax implications when selling.  This is particularly important if you have held something for a few years and have significant capital gains in that investment.  While capital gains generally receive quite favorable tax treatment in most jurisdictions, they are usually still taxed.  Recording a significant capital gain will incur tax liability that you must account for.  If selling to use the funds for other purposes, be sure to set aside some of those funds to cover the related taxes.  If you do not, you may be forced to sell other superior holdings at a disadvantageous time during the next tax season.