The best time to sell a stock is just before it starts going down but is it really as simple as this? I’m sure your answer must be a big NO! Why? Because it is difficult to time the turning points and selling a stock is more a function of educated estimation than a decision based on a formula-driven process.
Generally, one of the most important reasons for selling a stock is because the investor has found a new opportunity better than the one, he actually holds.
Apart from this, a couple of reasons for selling a stock are over-stretched valuations, the advent of new competitors, etc.
Therefore, from the above explanation, it is clear that you need to set a different standard when selling shares.
Selling a bull market leader is not the same as selling a solid compounding machine, which anyway would be different from selling dividend yield or a cyclical stock but an investor who does not know the art of selling, regardless of whether he is in a profit or loss, making wealth in the market is not a walk in the park, and moreover, maintaining what you have earned is even more difficult.
In this article, we would discuss the parameters that you can use to make the tough choice to hold or sell pretty straightforwardly.
Here are a few things to look out for to make the tough choice of selling a stock:
Simply put, market capitalisation (market cap) is the amount of money required to buy out an entire company at its current market price. Market capitalisation is one of the robust indicators of whether the stock is over or undervalued.
When the market capitalisation of the leader gets closer to an entire market size of the sector, it sends a definite signal of overvaluation unless there is just one company that constitutes a major part of the sector.
For example, the market capitalisation of IT bellwether in the technology bubble exceeded the revenues of the entire IT sector.
Change in the original thesis due to industries go through significant changes:
Sometimes, stocks need immediate attention because of a change in the original thesis under which they had been purchased as industries go through significant changes from time to time. Typewrites got substituted by computers totally.
As innovation takes place, existing products become irrelevant. As a result, an investor is introduced to a new negative aspect in the fundamental attribute of a business and this may result in a sharp decline in the stock price but given the fact that the original thesis has been troubled then, an investor should press the sell button as the original thesis changes completely.
When the present discounts the rosy future:
You must have probably heard the saying that the market is a ‘forward-looking mechanism’ or ‘discounting mechanism’. In essence, the phrase simply means that the market as a whole is more interested in what the future holds than in what happened in the past, or even what is happening right now.
Hence, the current market price of stock basically discounts or considers present information as well as events and potential future information.
As a result, in the case of a multiyear sector-led secular bull-run, the leading stock of the sector will extend both in price and valuation as long as growth is intact but if the growth falters, then this company will be derated to a new valuation matrix.
And recently, this was the case with IT stocks wherein, a multi-year bull-run happened as the trigger point was the outbreak of COVID, which brought about rapid change and we entered into a digital world; however, once this rosy future was discounted, the prices came to a grinding halt and we witnessed a steep fall.
In the above segment, we have covered things to look out for while selling a stock. Now, we will talk briefly about when not to sell a stock.
Here are the following reasons when not to sell:
A decline in the stock price:
Many times, we buy a stock only to see it go down by our purchase price; fear kicks in and we press a sell button. However, one should understand that in the short run, the market is just a barometer of investor sentiment and this might impact the stock price in the short run.
But, as long as the company does nothing wrong on the fundamental side, selling a stock just because there is a decline in the stock price could be detrimental.
A bad quarter or two:
There is a famous saying ‘form is temporary, class is permanent’. This applies to stocks as well; some stocks may face challenges due to adverse economic conditions or events like COVID and this may impact their earnings for a quarter or two but that doesn’t necessarily mean that the fundamentals have changed.
Just like in poker, knowing when to hold a hand and when to fold is crucial to every poker player’s success; for a stock market investor also, it is important to know when to fold and when to continue holding the stock.
(The author is Director, Choice Equity Broking)
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)