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Considerations for Deciding When to Sell a Stock by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research May 10, 2007 Excerpted from the Fall 2006 issue of On Investing, a magazine for Schwab clients. Most investors agree that it's more difficult to decide when to sell a stock than when to buy one. One reason might be that less than 10% of brokerage analyst recommendations are "sells," but a paucity of sell advice is only part of the problem. Successful stock investing requires a sell discipline to prevent hold/sell decisions from being driven by subjective criteria or emotions, rather than facts. When to sell The decision whether or not to sell a stock boils down to one rule: Sell an existing holding if a superior stock is available. But let's dig deeper into the considerations behind this basic premise. First, note that our sell rule implies that investment decisions should not be made in a vacuum. Every stock holding must be viewed as a personal choice vs. available alternatives. For example, a positive outlook for a stock is not sufficient reason to continue holding, if other stocks have even better prospects. The second and most critical element to applying our sell rule is determining if a superior opportunity is available. Let's dissect this task by restating our sell rule in a more elaborate form: Sell an existing holding if another stock compatible with the investor's risk tolerance is available that provides higher return potential after subtracting any taxes and transaction costs incurred in executing the swap. Therefore, to determine superiority one must estimate the following:
Items two through four are fairly easy to estimate, with a few caveats. Don't forget that transaction costs include a price for liquidity in addition to brokerage commissions. Every stock has a bid-ask spread quoted by the market maker(s) that quantifies at a given time how much more one has to pay to purchase a stock (at least 100 shares) than one would receive to sell the same stock. What's a Bid-Ask Spread? It's the amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. Bid-ask spreads tend to be fairly stable through time, so a useful rule of thumb in estimating liquidity costs for a small trade is half the current bid-ask spread. Capital gains taxes are simple to compute, but don't forget that capital losses also have positive value, either as income tax write-offs or as offsets against realized capital gains. (For details, please consult a tax expert.) Finally, understand that estimating portfolio risk impact involves more than comparing the risk of the stock to be sold vs. the purchase candidate. Even if the new stock is less risky than the stock sold, the swap could increase overall portfolio risk if the new stock is similar to current holdings, i.e., the portfolio becomes less diversified. Estimate returns By far, the most challenging aspect to making objective sell decisions is to estimate returns for existing holdings and potential swap candidates. But I would argue that it's difficult to have a sound sell discipline without such estimates. Hopefully, you employ a systematic process for identifying stocks to buy and have some idea of the expected excess return payoff over a set time frame. For example, let's say you favor stocks with low price-to-earnings ratio (P/E) and positive 1-year earnings per share (EPS) growth rates, and expect such stocks to return 3% more than the overall stock market annually. Consistent with this buy rule, you might consider selling a stock that no longer has a below-average P/E or rising earnings, expecting that such stocks might at best match market averages. In this scenario, as long as estimated transaction costs and taxes are less than 3% of your trade size, your portfolio's expected return will be enhanced by swapping positions (assuming constant risk). Common mistakes Unfortunately, in my experience, most small investors do not follow a systematic strategy, and those who do rarely can articulate their return expectations for any given stock. Just as damaging, investors often inappropriately introduce their cost basis into the return estimation process, which can lead to suboptimal behavior such as selling short-term winners too soon and hanging on to long-term winners and losers too long. Is it any wonder that academic researchers have found that the individual stock portfolios of most small investors fail to keep up with market averages? Simplifying the decision The good news for Schwab clients is that Schwab Equity Ratings can help simplify sell decisions. A- and B-rated stocks are expected to outperform the market over the next 12 months, while D- and F-rated stocks are expected to underperform. For a taxable investor, Schwab research simulations have found that selling stocks with ratings that have fallen to D or F and replacing them with A-rated stocks has historically provided market-beating portfolio returns on an after-tax, after-transaction cost basis. While these historical strategy backtests don't guarantee future performance, we do believe that a sell discipline using Schwab Equity Ratings is a sound way to manage a stock portfolio that is consistent with the considerations presented in this article. Next Steps For current equity ratings, log into Schwab.com and click on Quotes & Research, then Stocks. Go to the Schwab Large and Small Cap List to select from the pull-down menu. Important Disclosures Schwab Equity Ratings are assigned to approximately 3000 of the largest (by market capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks. Before considering whether to take any action, an investor should consider whether equities generally are performing well in comparison to other asset classes and whether other equities in the same sector or category with the same or better rating may be more appropriate. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue any investment strategy. Each investor needs to review a security transaction or investment strategy for his or her own particular situation. (0507-5951) Return to Top |
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