When to cut your stock losses and sell

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One of the most difficult decisions for investors is when to sell shares.

For instance when shares have seen a very substantial increase, some investors might like to take profits, as they believe that the share price will fall – other investors might take the opposite view and decide to let the share price run.

Similarly when share prices fall, many investors believe that the share prices will turn around and they don’t want to be in the position of selling at the bottom.

Indeed, some investors have a reluctance to sell any shares at a loss.

But the key element to grasp here is that if share prices have declined, then the investor has made a loss – whether it is crystallised or not makes no difference. The fact is, a loss is a loss.

In this case, investors must look at whether they would be better off in some other stock rather than waiting for the stock that they are currently holding to turn around.

Expressed in another way, if the shares which were in the loss-making situation were sold, and other shares (which the investor judges to be sound and with good prospects) were purchased in their place, and those latter shares increased while waiting for the original shares to turn around, the investor is better off by moving out of the loss-making shares and into the replacement shares.

Selling discipline

One way to alleviate investors anxiety about loss making shares is to have a selling discipline and to follow two fairly simple moves. The first is that when the share price is going up, investors should let the share prices run; the second is to cut your losses.

The real question then becomes how does one cut ones losses – what is the discipline.

My experience is that a reasonable selling discipline is that if the share price falls by 15% from its most recent high point, then investors should sell the shares no matter what.

In this way, one can always limit oneself to losing no more than 15% on any share transaction. Even more advantageously, one can actually lock in profit by using this discipline (that is, if the share price has risen above your purchase price before falling 15% below its high point, it may still be above your purchase cost).

My experience also indicates that more often than not when share prices fall by 15% from their most recent high point, the share prices tend to fall even further. When selling the shares once they drop 15% below their most recent high point, one should look for opportunities to buy other stocks, which one expects on reasonable assumptions to show an increase.

However, it is important to be alert to a situation where after the share has been sold, the share price starts to turn around and increase. In such a situation the investor should be ready to buy back into that particular stock.

The recovery

Examples of stocks that have declined substantially and then recovered a little would be our major resources stocks, BHP Billiton (BHP) and Rio Tinto (RIO). If one had sold either of these two stocks when they fell 15% below their high point, then one would have had ample opportunity to buy back into each of them when they eventually did show signs of stabilising and turning around. As the share prices of both BHP and Rio have fallen considerably more than 15% over the past year, the selling strategy would have paid handsome rewards.

More specifically, if one had sold BHP and Rio shares back in February or March of this year at around $38 and $66 each respectively, and transferred the proceeds into any one of the major banks, one would be substantially in front at the moment.

As of now, the four major banks have all increased by between 11% (NAB) and 27% (WBC) so far this year whereas BHP and Rio have actually shown very little overall movement as at November.

Stick to it

In summary, if one does opt for this 15% selling strategy, investors should stick to the discipline absolutely.

If an investor tries to finesse the disciple and say, “well there are no reasons why the stock should have fallen, its prospects look good, so I will hold on,” my experience again has shown more often than not (but not necessarily on every occasion) that the share prices tend to drop even further.

Importantly, it should be remembered that this strategy is a ‘more often than not’ rule, that is, it may not work all the time, but on average, I have found that it will work to your benefit more than it will work to your cost.

Michael Heffernan is a Senior Client Advisor and Economist at Lonsec Sharebrokers.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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