You can find dozens of books and hundreds of articles on how to buy stocks. When to sell them? A deafening silence.

It’s not just ordinary investors who struggle with selling. A 2021 paper looked at the performance of 783 institutional investors. These professionals outperformed the market with their buy decisions — and gave back some of that performance with poor sell decisions.

In fact, the selling performance would have been better had it been done at random. Authors of that study were Alex Imas of the University of Chicago, Lawrence Schmidt of Massachusetts Institute of Technology, Klakow Akepanidtaworn of the International Monetary Fund and Rick DiMascio of Inalytics.

The study covered 16 years (January 2000 through March 2016) and involved 2.4 million buy trades and 2 million sells. The authors concluded that portfolio managers devote “more cognitive resources to buying than selling.”

Five Methods

Many investors try to systematize their selling by using sell rules, or a “sell discipline.”

A paper by Ryan Kennedy at the Albany branch of State University of New York examined five sell disciplines often used by mutual-fund managers. The paper is a bit dated — published in 2012, using data from January 2003 to August 2008 — but I mention it because information of this type is scarce.

The best returns in the Kennedy study were achieved by funds that sell when a pre-determined target price is reached. Such funds had average monthly returns of 1.23%, which annualizes to 14.76%.

The worst of the six methods was the “opportunity cost” strategy, at 12.2% annualized. This is selling when you see another opportunity that seems considerably better.

Funds that sold when a stock became too expensive (i.e. a higher price/earnings or price/book ratio than the manager prefers) achieved the second-best results, 13.56% annualized.

In the middle were two other strategies: selling when fundamentals deteriorate (12.13%), and selling when a stock is down from cost (12.14%). This last method would include “stop loss” protocols such as “sell when a stock is down 20%.”

I applaud the study’s effort, but I see several problems. A sell discipline that works in one period might flop in another. Results for the five methods were closely bunched. And the five categories were rather broad. More sharply focused sell rules might do better (or worse).

Deterioration

There are many ways a company’s fundamentals can deteriorate. And several of them can generate sell triggers.

One rule is to sell when earnings decline. This can be a good guideline, because a decline in reported earnings sometimes means that a company has run out of ways to hide the bad news.

Selling when revenue declines also makes some sense, since that may indicate waning demand for a company’s product or service.

Selling if debt goes above a certain level gives you some protection against bankruptcy. Of course, you will want to know why the company took on more debt. It might be to fund an acquisition that will be great for profits.

Some people sell if inventories rise, or if accounts receivable rise (bad if the company’s customers are struggling). These can be indicators of trouble, but there also can be innocent explanations.

Combinations

Some managers, myself included, use a combination of sell rules. Here are my own sell rules.

One that I took from my mentor, David Dreman, is to sell any stock that has been held for three years with no appreciation. Critics would say that’s too long to wait. Be that as it may, at least it’s a limit.

Any decline of 20% or more triggers a hard look, and a decline of 30% calls presumptively for a sale. It’s a rebuttable presumption, however. If we’re in an environment like 2008, when most stocks were down more than 30%, a decline that size isn’t necessarily the kiss of death.

My attitude toward stop losses is influenced by the experience I had early in my career with Applied Signal Technology Group. I bought it at about $5. It fell to about $4 and then quintupled.

Had I used a hard stop loss at 20%, I would have sold Applied Signal at $4, missing an extremely pleasant gain. The company eventually was acquired by Raytheon.

I generally sell a stock if its price climbs (or its earnings fall) enough to push the price/earnings ratio over 30. Again, that’s a rebuttable presumption.

Finally, I sell a stock if I come to realize that my reason for buying it was faulty. How often does that happen? Somewhere between never and more often than I prefer to admit.

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