The Art of Selling a Losing Position

Your stock is losing value. You want to sell, but you can't decide in favor of selling now, before further losses, or later when losses may or may not be larger. All you know is that you want to offload your holdings and preserve your capital and reinvest the money in a more profitable security. In a perfect world, you'd always achieve this aim and sell at the right time.

Unfortunately, it isn't that easy in real life. When the housing bubble burst in 2007 and stocks started their descent into a bear market, investors froze. Many didn't even react until the value of their portfolio holdings had declined by as much as 50% to 60%.

Let's talk about the timing of selling stocks and then discuss a selling philosophy that works for any type of investor.

Addressing the Breakeven Fallacy

When their stocks are down, investors—like many during the 2007–08 financial crisis—say to themselves, "I'll wait and sell when the stock comes back to the price I originally bought it for. That way, at least I'll break even."

Firstly, there is absolutely no guarantee that a stock will ever come back. Second of all, waiting to break even—the point at which profit equals losses—can seriously erode your returns. Of course, we understand the temptation to be "made whole," but cutting your losses can be more important for long-term returns.

To demonstrate, the chart below shows the amount a portfolio or security must rise after a drop just to get back to the breakeven point.

A stock that declines 50% must increase 100% to return to its original amount. Think about it in dollar terms: a stock that drops 50% from $10 to $5 ($5 / $10 = 50%) must rise by $5, or 100% ($5 ÷ $5 = 100%), just to return to the original $10 purchase price. Many investors forget about simple mathematics and take in losses that are greater than they realize due to emotional distress. They falsely believe that if a stock drops 20%, it will simply have to rise by that same percentage to break even.

This isn't to say that rebounds never happen. Sometimes a stock has been unfairly pummeled. But the long turnaround waiting period—sometimes years—also means that stock is tying up money that could be put to work in a different stock with possibly better potential.

The Best Offense Is a Good Defense

Championship teams have one thing in common: a good defense. This principle can be applied to the stock market as well. You can't win unless you have a predetermined defense strategy to prevent excessive losses.

Having a defensive strategy, or exit strategy, in place before placing a trade hedges against emotional trading. Once we own something, we tend to let emotions such as greed or fear take over and get in the way of good judgment.

An Adaptable Selling Strategy

The classic axiom of investing in stocks is to look for quality companies at the right price. Following this principle makes it easy to understand why there are no simple rules for selling and buying; it rarely comes down to something as easy as a change in price. Investors must also consider the characteristics of the company itself. There are also many different types of investors, such as value or growth on the fundamental analysis side.

A selling strategy that's successful for one person might not work for somebody else. Think about a short-term trader who sets a stop-loss order for a decline of 3%; this is a good strategy to reduce any big losses. The stop-loss strategy can be used by longer-term traders also, such as investors with a three- to five-year investment time frame.

However, the percentage decline would be much higher, such as 15%, than that used by short-term traders. On the other hand, this stop-loss strategy becomes less and less useful as the investment time frame is extended.

Questions to Ask Before Selling

If you know your investing style and have put some thought into your investment, use this framework to help you think about whether or not you want to sell. Start by asking yourself these questions:

1. Why did you buy the stock?
2. What changed?
3. Does that change affect your reasons for investing in the company?

The first question will be an easy one. Did you buy a company because it had a solid balance sheet? Were they developing a new technology that would one day take the market by storm? Whatever the reason was, it leads to the second question. Has the reason you bought the company changed?

If a stock has gone down in price, there is usually a reason for it. Does the quality you originally liked in the company still exist or has the company changed? It is important to not limit your research to only the original purchase reasons. Review all of the latest headlines related to that firm as well as its Securities and Exchange Commission (SEC) filings for any events which could potentially diminish the reasons behind the investment.

If you have determined that there has been a change, then proceed to the third question: Is the change material enough that you would not buy the company again? For example, does it alter the company's business model? If so, it is better for you to offload the position in the company, as its business plan has greatly diverged from the reasons behind your original investment.

A Value Investor's Approach to Selling

Let's demonstrate how a value investor would use this approach. Simply put, value investing is buying high-quality companies at a discount. The strategy requires extensive research into a company's fundamentals.

1. Why Did You Buy the Stock? 

Let's say our value investor only buys companies with a price-to-earnings ratio (P/E ratio) in the bottom 10% of the equity market, with earnings growth of 10% per year.

2. What Changed? 

Say the stock declines in price by 20%. Most investors would wince at seeing this much of their investment fall. The value investor, however, doesn't sell simply because of a drop in price, but because of a fundamental change in the characteristics that made the stock attractive.

The value investor knows that it takes research to determine if a low P/E ratio and high earnings still exist. The value investor will also look at other stock metrics to determine if the company is still a worthy investment.

3. Does That Change Affect Your Reasons for Investing in the Company? 

After investigating how or if the company has changed, our value investor will find that the company is experiencing one of two possible situations: It either still has a low P/E ratio and high earnings growth, or it no longer meets these criteria. If the company still meets the value-investing criteria, the investor will hang on. In fact, the investor might actually purchase more stock because it is undervalued and selling at a discount.

With any other situation, such as high P/E and low earnings growth, the investor is likely to sell the stock, hopefully minimizing losses. This approach works with any investing style. A growth investor, for example, would have different criteria in evaluating the stock. But the questions to ask would remain the same.

The Bottom Line

Determining when to sell requires thought and work on your part to ensure these guidelines maximize the effectiveness of your investing style. All investors are different, so there is no hard-and-fast selling rule that all investors should follow.

Even with these differences, it is vital that all investors have some sort of exit strategy. This will greatly improve the odds that the investor will not end up holding worthless share certificates at the end of the day. Know what your investing style is and then use that strategy to stay disciplined, keeping your emotions out of the market.