4 Reasons to Dump a Stock

Investors can often hesitate to sell stock, hoping that the company or market will rebound and the stock’s value will soar. But smart investors recognize these four scenarios when selling a stock is the wisest move:

1. The stock is fairly priced or over priced.

One of the best reasons to sell a stock is when the stock is fairly priced or overpriced by the market. “Buy low, sell high” is easier said than done, of course. Investors should determine an exit point at which the business is being fairly valued by the stock market, unless the stock is one the investor intends to hold forever.

Just as investors should analyze stocks to determine which are undervalued by the market and will appreciate in value, investors should analyze their own holdings of stocks to determine which are currently fairly priced or overvalued.

It can be difficult to part with a stock even when the analysis indicates that it is overvalued. The reason for this is that human psychology causes people to place a higher value on things they own than things they don’t own. In addition, a stock with a large run up in price may give investors reason to believe the price increases will continue. These are not good rational reasons to hold a stock, and investors should stick to their analysis and exit positions accordingly.

2. Your investing idea turned out to be wrong.

Another reason to sell a stock is when the investing idea (or “investment thesis”) behind buying the stock turned out to be wrong.

For example, an investor who purchased shares of a construction equipment company because the investor believed the economy would improve in the next year should sell those shares if the economy does not improve. In another example, an investor who bought shares of a consumer products company believing their new product would lead to a large growth in sales should sell those shares if the product turns out to be a flop.

Investors should write down their reasons and analysis for buying stock in a given company. If at any time while holding those shares, the investor’s reasons or analysis turns out to be false, the investor should sell the shares he or she accumulated in the company.

A failure to do this will lead to investors holding shares in companies without rational reasons behind holding those shares. The stock market is inherently about the future, and the future is inherently uncertain, but investors do themselves no favors when they create ad hoc reasons to continue to hold stocks when their reason for buying those stocks is no longer true.

3. You find a better opportunity.

Every investor should be careful to monitor his or her stock portfolio, and only hold positions representing his or her best ideas. It makes no sense for an investor to over diversify among dozens of investing ideas. Ideally, a stock portfolio will represent no more than the top 10 or 15 investing ideas an investor has.

Therefore, an investor may periodically review his or her portfolio and decide that a new investing idea is better than one for which the investor currently has a position open. Assuming that the investor is now well diversified and the new position will not harm the investor’s diversification, the investor should sell stocks that represent one of the investor’s lesser investing ideas.

4. There is a permanent impairment to the business.

This last reason is perhaps the most painful reason to sell a stock—when there has been a permanent impairment to the underlying business. If an investor has bought a stock expecting the company’s future to look like its recent past, the investor should not hesitate to sell the stock when it becomes apparent that the company’s business has significantly deteriorated.

Selling a stock in this situation can be difficult to do because no doubt an investor will take a substantial loss. Investors often want to hold on to stocks when they fall hoping the stock prices will make it back to where they were before the decline. However, this is an investing mistake.

There is nothing wrong with investing in companies with poor business prospects, provided the market appears to be undervaluing the company. But an investor who bought believing the prospects for the company would be good or average should not hesitate to sell when the company’s business prospects become poor.

If the investor fails to sell, he or she becomes the owner of a bad business without a detailed analysis of why the market is undervaluing the business. That is a dangerous investment mistake to make.

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