Exiting a Stock: Knowing When to Sell - Part 1
The power of cutting your losses : How to improve your portfolio returns
In the last blog, we discussed the four steps of investing which are:
Choosing the right stocks (What to buy?)
Deciding how much to invest in each stock (How much to buy?)
Deciding when to buy the stocks (When to buy?)
Deciding when to sell the stocks (When to sell?)
This time, we're going to take a closer look at the fourth step: deciding when to sell the stocks.
Selling stocks is a crucial step in investing, as it can determine whether you make a profit or a loss. It's essential to have a plan for when to sell your stocks, so you know when to lock in your profits or cut your losses.
There are two main reasons for exiting a stock:
The stock's upside potential is capped: This means that the stock has reached its peak price and is unlikely to go up much more. For example, if you bought a stock for $100 and it doubled to $200 in a year, it's likely that the potential for further price increases is limited. You would want to exit and take your profits. You can use technical charts or fundamental analysis to identify the exit point. I’ll cover this in the next blog.
The downside risk is high: This is when a stock's price is dropping and there's a chance that you'll make a loss. For example, if you bought a stock for $100 and it's now down to $70, you have the option to either hold on and hope the price will go back up, or cut your losses and preserve your capital.
In this blog post, I will delve into the crucial topic of determining the appropriate time to sell a stock when its performance begins to decline.
When deciding to sell a stock, emotions can play a big part. People often want to sell a stock when it's doing well but hold on to it when it's not doing well, hoping the price will go back up.
This phenomenon is commonly referred to as the "disposition effect," which is the tendency for individuals to sell their winning investments too early and hold on to their losing investments for too long.
Credits : StockAxis
This behavior can lead to underperformance relative to a strategy of selling losers and holding on to winners. This is because if investors sell their winners too early, they may miss out on additional gains, and if they hold on to their losers for too long, they may experience larger losses.
Research has shown that this behavior is driven by a variety of psychological factors, such as the desire to realize gains, the sunk cost fallacy, and the pain of recognizing a loss.
However, this is not a good strategy. Instead, it's better to "cut your losses short and let your winners run."
Why do we need to book our losses quickly ?
I’ll give two exhibits to drive this point
Losses are asymmetric in nature : One key concept to understand is that losses are asymmetric in nature. This means that the larger the loss, the more gain is required to recover.
To illustrate this point, take a look at the table below:
How to read the table —> If you lose 10% of your portfolio, you need 11% gains to break even. If you lose 20% of your portfolio, you need 25% gains to break even.
As you can see, the negative asymmetry of losses compounds as the loss increases. This is why preserving your capital is crucial to stay in the game of investing.
Cutting your losses can boost your overall portfolio returns : Now, let's take a look at an example of how cutting your losses early can boost your overall portfolio returns.
We'll consider three investors: Rakesh, Harshad, and Saurabh. Each of them has 1 lac of capital and has picked the same 4 stocks to invest in equal proportion.
Rakesh is prudent with risk and always caps his losses at 10%, whereas Harshad is lenient with risk and caps his losses at 20%. Saurabh doesn't cap his losses at all.
Here's how their portfolio returns compare :
As you can see, Rakesh & Harshad had the same selection of stocks as Saurabh, but Saurabh went on to hold loss-making stocks which dampened his overall returns, whereas Rakesh & Harshad cut their losses early and let their winners run this resulted in a better overall portfolio returns for Rakesh and Harshad.
Credits : StockAxis
In simple terms, capping losses is important to avoid losses from compounding and to keep your capital safe, this way you can stay in the game of investing for longer time and your portfolio will perform better even with mediocre stock selection as compared to portfolio of excellent stock selection with uncapped losses.
The ideal cut-off point for exiting a stock will vary depending on your investment goals and risk tolerance.
I prefer a stop loss of 10% while trading. While investing a hard stop of 20% , as stock prices can fluctuate over time.
What is your Risk management approach ?