Jon writes about the decision to sell a stock in his blog novel investor. Seth Klarman describes selling as “the hardest decision of all.” That would make buying the second hardest decision. But once something is bought, those emotional triggers still exist, only now your money is at stake, along with a new issue of knowing precisely when to sell.
Klarman says that many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.
To deal with the difficulty of knowing when to sell, some investors create rules for selling based on specific price-to-book value or price-to-earnings multiples. Others have rules based on percentage gain thresholds; once they have made X percent, they sell. Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell.
None of these rules makes good sense. Indeed, there is only one valid rule for selling: all investments are for sale at the right price. The reason to sell should be based on value. If you bought it because it was cheap, you should sell because it is no longer cheap. If you bought for other reasons, then the reason to sell is harder to pin down, making it easier to sell for stupid reasons like price moves, big headlines, what your crazy uncle said, or any other excuse you come up with at the time.
Jon concludes that simple rules are the best option, if unbiased valuation isn’t your strong suit. Rules beat having no reason and excuses, certainly. Rules also provide consistency at times when it is needed most by making an unemotional decision — for action or, more importantly, inaction — in a system that frequently overwhelms emotion.
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