Timing your exit strategy
Getting into a stock is the easy part. Here are four tips for knowing when to bail out.
(FORTUNE Magazine) – Buy low, sell high. for the most part, professional stock pundits and the media (FORTUNE included) spend a disproportionate amount of time on the buying part of that formula and pay only passing interest to the selling. But knowing when to sell is crucial to your financial (not to mention psychological) well-being. Here are four tips for working through this all-important decision.
* Forget what you paid. Many people get hung up on the price of their initial investment--at the expense of their own bottom line. "What you paid for the stock is irrelevant," insists Ron Muhlenkamp, whose eponymous mutual fund has handily beaten the S&P 500 over the past decade. "The only thing that's relevant is the current value."
* Check for fundamental change. The fact that you may have a big gain or a big loss on a stock is not by itself a reason to sell. "The key is, Has the story changed since you bought the stock?" says Stuart Freeman, chief equity strategist at A.G. Edwards. It may be tempting to believe that, say, Delta Air Lines can bounce back from $6 a share to the $15 you paid for it a couple of years ago. But ask yourself a few essential questions: Have new competitors entered the fray? Have the company's customers changed their spending habits? Has a price war erupted in the industry? In Delta's case, that would be yes, yes, and yes. And with no profits in sight, it's time to think about selling.
* Keep an eye on P/E. What if the story hasn't changed, but the stock has run up far faster than you expected? Do you sell or hang on for more? Take a look at the price/earnings ratio--the stock price divided by earnings per share. (In general, it's better to calculate the ratio based on actual profits rather than rely on estimates of future earnings.) If the stock you own has spiked enough to drive the P/E to more than 1.5 times the market average, consider taking some profits.
For example, if you bought tech-gizmo maker Research in Motion a year ago at $10, you're sitting on a 500% profit. Sure, that gain has been fueled by impressive growth in the company's sales. But at the current price of $62, the stock is valued at a stratospheric 73 times the past 12 months' earnings (compared with a P/E of 19 for the S&P 500). "It's trading on news and emotion," says Muhlenkamp.
* Plan ahead. Sometimes the hardest step is to take profits on a hot stock--you keep thinking about all the money you'll miss out on if it keeps going up. If you're having trouble pulling the trigger, consider using a stop order, which instructs your broker to sell if the stock slips to a designated level--say, the point at which you'd lock in 90% of your current paper gain. If the stock continues to rise, you're a genius. But if it begins to swoon, you'll keep most of your profit without having to make a sell call in the middle of a meltdown. "I like the stop order because it's a decision you make when you are in a rational frame of mind," says John Nofsinger, author of Investment Madness: How Psychology Affects Your Investing. "As soon as a stock moves, you become emotional about it."