Knowing When to Sell, and Why.

I was originally going to compile a list of other blogs and information to give you the reader an idea on when selling a stock is a good idea. However I could only seem to find anecdotal tales of high returns and no such general formula, which is why I didn’t get a post up yesterday. So for today I have opted to provide the formula to you on how I view selling a stock should go.

First and foremost we need to make clear the distinction between realized and unrealized gains. This is very important to how you can measure your portfolio’s (and subsequently your wealth’s) growth. So to begin here is a short scenario:

You at some time bought 100 shares of ABC Company for $15/share. A few months later, the price has moved up to $24/share.

At this time you have made an unrealized profit of $9/share or around 900 dollars. It is unrealized because that extra $900 hasn’t actually been paid to you until you sell some amount of stocks and collect it. Once you have done so, the profits are then realized. This is important mostly because regardless of what your broker tells you or what you see on your tax forms, you haven’t actually made any money until you cash out, or as Jim Cramer says “rung the register.”

So when is a good time to ring the proverbial register? Here’s my 5 steps to knowing when it’s a good time to sell a stock:

Start With a Game plan

When you are getting ready to invest in a company or multiple companies, you need to first determine how many stocks or funds or whatever you want to be in. Some professionals recommend no more than five or so, as it can be difficult to keep up with a large number of different stocks. In that case, you would want each stock to account for no more than 20% of your portfolio (100%/5 stocks=20% per stock). If for example you wanted to invest in 10 stocks, then each should be 10%.

Monitor Your Holdings for Large Gains or Losses

The market itself is quite the fickle creature and as such will move up and down on what may seem like a whim. It’s your job to monitor the number of stocks you’ve chosen to see how far from your initial buy price each one has moved. Let’s use this example portfolio for now:

Stock             $ per Share     $invested      #shares         Dividend       Total Value   % of Port

ABC 10 1000 100 3% 1000 10%
DEF 20 1000 50 3% 1000 10%
GHI 25 1000 40 3% 1000 10%
JKL 15 1000 66 3% 1000 10%
MNO 30 1000 33 3% 1000 10%

You’ll notice I used some generic numbers (like a 3% dividend for each company) so the math is easier, but the point will remain. It’s also worth noting for the math that our starting portfolio value is $5000. Now, let’s assume we are checking our portfolio at the end of the quarter and see these changes:

ABC 12 Na 100.3 1203.6 20%
DEF 17 Na 50.75 862.75 14%
GHI 29 Na 41 1189.00 20%
JKL 26 Na 68 1768.00 29%
MNO 27 Na 34 918.00 15%

Our new portfolio value is $5940. We can see now the adjustment to how much each stock is in relation to the total value of the portfolio. So that leads us to step 3.

 Buy or Sell a Position to Maintain Your % Split

Based on the above charts, we should sell some of our position in JKL and take advantage of the major spike in price. To get back to the 20% range, the total value of shares needs to be around $1,188 which means we want to sell around $600 in shares or about 23 shares of the stock. We then would take that $600 and reinvest it into DEF and MNO to bring them back up to the 20% mark.

These Are Guidelines, NOT Laws of the Universe.

An important point to remember is that #3 works “in general” assuming the five companies you chose are good companies for long term investing. If companies DEF and MNO turned out to be junk, then you may consider using that extra money from JKL to get into different companies and then sell off the other two completely once they bounce back some (closer to your buy in price). By utilizing #3 correctly, you can take advantage of market movements, and claim your big wins, while also growing your portfolio at a discount. In the case of DEF, if that company is still a great buy, then you are getting to pick up more shares for less, which is always a win.

There is a Margin of Error, The % Need Not Be Perfect

There will often be times when you have a much closer spread on your account. Maybe for example your %s are 21,20, 19,18,22. In cases like this, a sell off isn’t necessary or encouraged. This is a sign is minor market fluctuations and shouldn’t be stressed over. As far as buying in this case, make sure you buy in an even amount, so that once purchased, you holdings will go back to as close to 20% across the board as you can. For example, you may have an extra $1,000 dollars. Instead of putting $200 in each (which you can do, and is a perfectly fine option when in this position) you could spread it as such: 190,200,210,220,180. Thus, bringing your amounts closer to the mean.

While these are not hard and fast rules, I hope this short exercise will give you some more general ideas on when to sell off a portion of a position due to spike in price. A good way to track this is to make an excel spreadsheet with your stocks and update it periodically with current information. If you program the equations in correctly, it will properly calculate your portfolio percentage and tell you whether you should be buying or selling.

One other tip I would give is, don’t let the 20% rule prevent you from making constant investments into your portfolio. If you have to have your numbers periodically skewed to take advantage of your budget and what you can afford to invest in, that’s ok, so long as you shore it all up every so often to protect yourself with even diversity. It’s also worth noting, that when a stock goes on sale, buy it. Like earlier, even if it messes up your percentages a little, don’t pass up a bargain or possible money making opportunity, because it may cause one of your holdings to go over the 20% mark. Hope this is informative and useful. Till next time.

-D

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