How do you know when it's time to sell?
Psychology plays a huge role in making the decision to sell. History is littered with examples of greed or other bad behaviors that get in the way of what, in hindsight, turned out to be a great opportunity to take some profit off the table.
During the last few years, we've seen several stocks reach all-time highs, and I'd hear people wondering about whether it's time to sell only to balk because they didn't want to deal with the tax burden.
This approach to selling is a little bit like letting the tax tail wag the investment dog. Sure, considering potential taxes should be a part of the investment decision, but it shouldn't be the deciding factor.
So if you find yourself in the enviable position of having chosen a few winning individual stocks, and you're willing to look beyond the taxes, how do you make the decision?
First, it's often better to be lucky than smart, so it makes sense to be honest with yourself if you happened to get in on a stock at just the right moment. As you watch the price go up, ask yourself the question, did you make the decision to invest because you're smart, brave, or just lucky? If you're being honest, most people would acknowledge that when you pick an individual stock or two and they subsequently triple in price, that outcome is more often than not a result of luck and not some inherent skill.
Second, review how these investments fit within the context of your financial life. Choosing to keep an individual stock just because it went up does not qualify as a valid reason. So when you're asking the question of whether it's time to sell, take a step back and consider the following:
1. Clearly identify your financial goals.
A simple (but not easy) process, identifying your financial goals should include defining what you think you want the future to look like. Don't spend hours or days on this task, and give yourself some slack. It's life, after all. Things will change, and it makes sense to revisit and redefine your goals periodically. These goals really are nothing more than educated guesses, but they're at least a set of markers in the sand, something that you can use as a reference point for your decision-making.
2. Make a plan to get there.
Again, don't spend too much time here, because the variables that go into building a plan are nothing more than guesses. Still, the process is important. Using the information you have, estimate how much you can save for the next 36 months, make a guess at the rate of return you hope to earn and carefully consider what risks you're comfortable taking.
3. After you define some goals and build a simple plan, decide if your current investments fit the plan.
4. If the investments don't fit, sell!
Now, you need to be prepared psychologically to sell. I can promise you that if you make the decision to sell an investment because it aligns with your plan, the stock will triple over the next couple months after you sell.
If you make the decision to continue to hold an investment because it does fit in the context of your plan, it will lose 20% of its value over the next three months. There's no guarantee that comes with the decision to buy or hold, but be prepared that your decision may be tested. That's just Murphy's Law.
Making the decision to sell or hold an investment is relatively simple when we're aware of the cognitive traps of fear and greed. It should be clear to anyone that if you own an investment that has tripled in price, and you made that investment based on luck, it would be wise to take some of the profit and go home.
Investment decisions like buying or holding are best made when you do so in the context of your financial goals. Picking the next Apple or Google is not a financial goal. Saving for retirement or having enough money to send your kids to college are financial goals. Once we're clear about the why, about the goals, and we have a simple framework to represent a plan to get there, making investment decisions becomes much more simple.
A version of this post appeared previously at The New York Times.
Carl Richards is a financial planner and the director of investor education for the BAM ALLIANCE, a community of more than 130 independent wealth management firms throughout the United States. Visit Behavior Gap for more of Carl's sketches and writings.
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