Performance (good): How long are you going to keep a stock that's making money? Under what circumstances will you take a profit? What if it becomes a huge winner -- at what point will you rebalance your portfolio?
While many people are concerned about what to do with a loser, they often forget that you need to plan for how to handle a winner. I employ a few strategies for dealing with this. First, I like to watch the uptrend -- if and when that's broken, that's certainly a good reason to sell some of the position.
Several successful traders I know use a simple 20-day moving average; when that cracks, they take profits. Another strategy is using the prior month's lows -- anytime a stock that's been moving higher breaks the previous month's lows, it's a sign that the trend may be over. This method can keep you in a strongly performing stock for several years.
Lastly, if a big winner gives back more than 25% of your gains, you may want to protect the rest of those profits by selling the stock.
Before you select one of these methods, play with them to see how they fit you style. Back-test these tactics to see how long they would have kept you in the few stocks that have been working this year -- the homebuilders, defense plays or integrated oils -- and where you would have gotten out of tech and Internet names from the 1990s. The key is finding a methodology that works for you.
Original rationale: Once the underlying reason that prompted you to buy a stock goes away, sell the holding. Period.
For example, earlier this year I thought there was a good chance that
was going to merge with
. Carl Icahn had accumulated a large chunk of stock in both companies. A turnaround story, a billionaire investor and a merger meant there was potential upside for a name widely disliked by Wall Street. After a competitor,
, won the bidding war for Hollywood Entertainment, it was apparent that plan was not coming to fruition.
With my original reason for owning the stock gone, I had no choice but to sell the stock for a small loss. A month later, bad news hit, sending Blockbuster down 30%.
This is a hard and fast rule of mine: Never hold anything once your original reason for ownership disappears. Whatever other reason you come up with is only an after-the-fact rationalization.
Fundamental changes: When the fundamentals change for the worse -- and you've defined this in advance -- that's as a good a reason to sell as any. Unfortunately, by the time most investors realize that the fundies have changed, the stock is usually significantly lower. This is typically the worst reason to sell, timing-wise. But you can often avoid even more bloodshed by exiting the stock, especially if its entering a cyclical period of poor performance.
Time: How long are you going to wait for this dog? You simply want an understanding -- in advance -- of the period of time you will be willing to wait for a stock to produce.
If a company is a slow grower with a good dividend, you might be willing to give it awhile -- even a few years. If it's a potential explosive grower awaiting a key catalyst, you might be less patient, giving it only a few quarters. Some trades may get a 90-day grace period, or less. But decide
you own it.
For Better or Worse
A marriage pre-nup is designed to protect your assets before the honeymoon begins. Experience suggests that once the dishes are being thrown, having an objective, unemotional discussion about who gets what is all but impossible.
The same thought process governs the stock pre-nup. It's designed to maximize your retention of assets in the likely event of an ugly equity break up. And it doesn't even need a lawyer!