There is no shortage of financial literature about when to buy a stock, but determining a strategy for holding or selling a stock is also important. Investors must consider several factors before buying or selling an investment, including how much risk they're willing to take and when they'll need the money.
In other words, investors should have a financial plan that outlines their investment and financial goals for the short and long term. This article will look at some of the factors for when and why investors might sell a stock.
Key Takeaways
- Selling a stock is just as important and intensive of an operation as buying a stock.
- Investors should create a strategy for buying, holding, or selling a stock that considers their risk tolerance and time horizon.
- Investors might sell their stocks is to adjust their portfolio or free up money.
- Investors might also sell a stock when it hits a price target, or the company's fundamentals have deteriorated.
- Still, investors might sell a stock for tax purposes or because they need the money in retirement for income.
Understanding When to Sell or Hold an Investment
Knowing whether to hold onto a stock or sell it can be a challenging decision. There is no universal, one-size-fits-all strategy for selling a stock. Instead, it's up to the individual investor's investment strategy based on many factors, including their risk tolerance, time horizon, and financial goals.
If an investor is unsure as to how to develop that strategy, they should educate themselves or contact a financial professional to help them develop an investment plan that matches their financial goals. Below are some of the reasons investors might sell a stock.
Time Horizon
An investor must determine their time horizon before purchasing stocks or any type of investment. If an investor has a long-term time horizon, they can likely ride out market corrections or downturns. However, if the money is needed in the short term, such as less than one or two years, investors will likely have a different strategy for holding or selling their investment.
Each investor will also have a different financial goal, depending on their age and when they need their money. If an investor is 25 years old, they might hold their investments for several years. Conversely, if an investor is a retiree or close to retirement, they would likely have a shorter time horizon, particularly if they need the cash for retirement income.
Risk Tolerance
Risk tolerance is the level of risk an investor is willing to take for each investment. Some investors will forgo a significant rate of return in order to achieve lower risk. For example, U.S. Treasuries are considered risk-free assets as long as they're held until their maturity or expiration date. In return, investors are paid a rate of interest.
However, U.S. Treasuries would likely underperform stock investing. An investor with a higher risk tolerance would likely put their money in stocks, such as an index fund that tracks the . Understanding risk tolerance, investors can develop a strategy for what types of stocks to buy, how much money to allocate to stocks versus bonds, and when to buy, sell, and hold their investments.
Buy and Hold
If investors are holding an investment for the short-term or less than one year, they might sell the stock as soon as it makes a capital gain or when they need the cash. However, a popular long-term strategy is called a buy-and-hold strategy, which is a passive investment strategy in which an investor buys stocks and holds them for a long period of time.
Buy and hold investors are less concerned with short-term fluctuations in the stock market. Buy and hold investors typically choose stocks based on a companies long-term financial fundamentals, such as the company's revenue or profit potential.
Also, buy and hold investors tend to look for companies with a strong management team and a consistent track record of generating earnings from sales. However, even buy-and-hold investors might need to sell a stock at some point for a profit or loss. As a result, investors should be aware of their purchase price and any change in the company's fundamentals.
Reasons to Sell a Stock
Below are some key factors to consider when making an investment decision to sell a stock.
Adjusting a Portfolio
A common reason to sell stocks is to adjust a portfolio. There are many reasons that a portfolio might become unbalanced or inappropriate for your investing goals. This couldbe due to a life event, such as a marriage, divorce, retirement, the birth of a child, or merely an accidental concentration of capital in one sector.
Putting all of your stocks in one sector—or even putting all of your money into a certain risk level of investments can be risky. Diversifying a portfolio can help reduce risk by spreading out the investment into multiple stocks, sectors, or investments. If one stock or sector declines, the portfolio can weather the loss better since the money is allocated throughout many investments. The process is called asset allocation, which helps balance risk and reward by allocating a portfolio's assets according to an individual's financial goals,risk tolerance, andinvestment time horizon.
However, even a diversified portfolio can experience losses. Selling a stock to shift the money into other investments can help achieve improved long-term gains. For example, if a stock or sector is underperforming, an investor can reallocate the funds to other better-performing areas of the market.
Freeing Up Capital
Investors also sell investments to free up their money or capital.The money could be neededto make a down payment on a house, finance a new business, pay for medical expenses, ortake a vacation.
A Stock Hits the Price Target
Many investors use price targets to determine when to sell a stock. Investors that use the strategy typically will determine a price range for when to sell the stock at the time of purchase. As a stock price rises, investors can begin selling the position once it reaches the price target range. Investors can either sell it all at the price target or ease out of the position over time at various price targets.
Change in Fundamentals
Sometimes investors may need to sell a stock when the company's fundamentals change for the worse. For example, investors may begin unwinding their position if a company's quarterly earnings have been steadily decreasing or performing poorly compared to its industry peers.
While owning a stock that you plan to hold for many years, it's important to monitor the company's fundamentals by analyzing its financial statements and keeping tabs on its sales, revenue, and management performance. If it turns out that the company isn't performing as planned, you might want to consider selling the stock before the financial situation gets worse.
A buy and hold strategy only works if your research is correct and the company continues to execute its business plan and generate earnings. However, things can happen that are out of your control.
For example, technological advances might make the company's products obsolete or uncompetitive. A company might also be involved in a scandal. For example, Enron was once viewed as a stable, reliable company in which its stock traded around $90 per share in mid-2001. However, once its illegal accounting practices were revealed, the stock plummetted to $.60 per share.
Understanding and monitoring a company's fundamentals are critical when investing in individual stocks. Investors should educate themselves on how a company earns revenue, its profit, and how dominant of a player it is versus its industry.
Opportunity Cost
Investors might sell a stock if it’s determined that other opportunities can earn a greater return. If an investor holds onto an underperforming stock or is lagging the overall market, it may be time to sell that stock and put the money to work in another investment. Investors must also consider the time horizon for how long they want to hold a stock since a long-term holding that’s returning very little can be an opportunity cost.
Change in Ownership or Merger
Sometimes it may make sense to sell a stock if a company has been acquired or merges with another company. Many times the stock price can rise dramatically if it is acquired for a significant premium. As a result, investors may sell the stock after the merger. However, it’s important to determine whether the company's fundamentals are better after the merger or acquisition and if not, it may be time to sell and put the money elsewhere.
Technical Signals
Investors familiar with technical analysis and charting can use various indicators to analyze stock price movements and establish a predetermined sell signal.
For example, a simple moving average (SMA) represents the arithmetic mean of the closing prices over a specific period. If a stock's price declines so that its 50-day moving average (MA) crosses below its long-term 200-day moving average, it might signal a change in its trend. It also could signal that the company's fundamentals have deteriorated or that economic conditions for the sector have changed.
If investors believe that a moving average crossover will lead to a prolonged downtrend, they might unwind the position. Many technical indicators exist that can help investors monitor their stock portfolio and help them make more-informed investment decisions.
A Market Selloff
Some investors can't hold onto a stock forever and ride out market corrections and large selloffs. If an investor needs the money in a few years and a recession occurs, it might be another few years before the investment recovers to pre-recession levels.
As a result, buy and hold portfolios can lose some or all of their gains. A few bad stocks might be enough to drag the portfolio into a negative return. Merely holding a well-run company doesn't guarantee the stock price will rise indefinitely. In particular, those in retirement should be careful as to the level of risk being taken when investing since the money will be needed to provide income.
Tax Treatment
Investors may sell a stock that's experiencing a loss and unlikely to get back to profitability. The loss can be used to offset capital gains realized on other stocks and, perhaps, lower the tax bill. However, a buy-and-hold strategy can help to lower capital gains taxes. A stock held and sold for a period greater than one year might be taxed at the more favorable long-term capital gains tax rate instead of the higher, short-term rate.
Please consult a tax professional to review your specific financial and tax situation before selling a stock or investment for tax purposes.
Deciding Which Shares to Sell
Before selling, it's important to consider which stock will be sold first because it can impact your tax situation. Typically, a stock that's sold is done so on a first in, first out (FIFO) basis unless otherwise stated.
For example, let's say you bought 50 shares of a company every year, and over the course of four years, you paid $10, $15, $20, and $15 per share, respectively. Suddenly, you need money for an emergency and the stock is trading at an all-time high of $25 per share.
If you decide to sell 50 shares, typically, the first year's shares at $10 per share would be sold. If you wanted to hold onto those shares, you can select which shares to sell at the time you place the sell order. In other words, you can select the shares that you paid the most for($20), which can lessen the amount of capital gain and, as a result, the amount of taxes paid.
Of course, if you sold the shares with the $20 purchase price for $25, you'd only have a gain of $5 per share realized. If the stock price falls back to $15, you would have missed out on earning a $15 per share profit on the shares bought in the first year for $10 per share.
The Bottom Line
Selling an investment is like buying one—you have to make sure it is in line with your investing and financial goals. Also, it's important to understand your risk tolerance and time horizon. Please consult a financial adviser to help you develop a short and long-term financial plan.
