There are two important sides to successful, profitable portfolio management. One key component is identifying and investing in fundamentally strong companies. But equally, if not more important at times, is knowing when to sell a security.
Unfortunately, this is the part of the investment process investors get wrong most often.
During my years as a portfolio manager overseeing mutual funds and institutional money, I learned that what is often more important than owning a portfolio of strong performers is being able to offload the underperformers. Owning one or two stocks that collapse in value can potentially wipe out all of your portfolio gains. That is why owning a diversified portfolio of stocks, with low correlations, operating in different industries, is so important. Diversification helps reduce risk. So if you have one stock that plunges in value, the damage to one's portfolio is limited, and stocks owned in other sectors can hopefully offset the loss.
An interesting phenomenon occurs for some investors when faced with gains and losses. When there's a gain, they worry about losing their profits – they become risk adverse. A small profit will heighten investors' nervousness and they will want to sell and exit their position to lock-in their profits. Yet, the opposite occurs when investors are facing a loss. When this occurs, investors accept greater risk – their risk tolerance increases. Investors will come up with justifications to hold on to losses, such as hoping for a turnaround or arguing that the stock is cheap, instead of facing the pain of cutting their losses.
Holding on to underperforming securities is a frequent investment mistake for two main reasons. First, there is the possibility that the loss may grow. In some instances, the share price may decline in value so much that it reaches a point where you don't care about the relatively low value of the stock in your portfolio. Mentally, you write the stock off as a loss while it remains in your portfolio. The other mistake is the opportunity cost of not selling and being able to buy a different security that may appreciate in value.
Here's a simple analogy to consider when faced with selling a stock. If you had a friend in your life who was constantly criticizing you and bringing down your spirits, what would you do? You may perhaps try to see your friend less often, or may even decide to never see that person again. The same response may be prudent when it comes to stock holdings. If a stock is dragging your portfolio down, do your research and determine if the sell-off is due to a temporary issue or to issues that are likely to persist and remain an overhang on your investment for some time.
Given that it is human nature for many investors to hesitate to sell a stock at a loss, I recommend making an exit strategy before buying a security. Before you purchase a stock, ask yourself: at what share price will the loss cause you stress, anxiety, and regret? Perhaps it is a loss of 10 per cent or 20 per cent. Determine the figure before investing, and after purchasing a security, set up a price alert that will notify you if a security falls to this level (such a feature is available on Globe Investor's Watchlist). Then, if you receive an alert, you can be aware and reassess your stock position. If the entire market is falling due to some non-company specific factor, such as Brexit, then you may not want to sell.
How to time the exit from a stock holding is one of the most frequent questions I get asked from readers. My advice: when you have a profit, taking some of the gains off the table is prudent. However, if industry and company fundamentals both remain favourable, maintain your position.
When faced with a loss, investors need to focus on the cause. If the company is facing temporary headwinds, you may want to ride it out. However, if the industry and company fundamentals are deteriorating, cutting your losses and moving on can be an effective, successful portfolio management strategy.