Three Keys to Selling When the Time Is Right

Editor's note: This Weekend Edition, we're taking a break from our usual fare. In this essay, most recently published in the Stansberry Digest Masters Series, Dr. David "Doc" Eifrig details his three keys to selling investments... and explains why learning how to sell is paramount for successful investing.

One of the keys to successful investing is learning how to sell.

Knowing when to sell is half the battle... but you also must have the discipline to follow through on your plan.

Sometimes greed can slip in at the last minute... so sticking with a plan to sell is critical to protecting your profits. It also allows you to look for more opportunities to put your capital to work in investments just like the one you closed.

Let's start with my three keys to selling investments...

First... whenever you invest in something, write down why you bought it. This means literally getting out a piece of paper or an index card (or opening a spreadsheet) and writing down your reasons for owning the stock. Maybe you bought it for dividend or interest income or for potential growth-driven capital gains.

You should note any data or metrics that support your investment decision. For example, a low price relative to its earnings or cash flow.

Second... write out when you'll sell the investment. Do it on the same piece of paper and at the same time you're buying the investment. This includes writing out your expected percentage return and time frame.

This is important, as it expresses your plans before you become emotionally attached to the act of purchasing the investment. Once you own something, "confirmation bias" – the tendency to favor information that confirms your beliefs – can cloud your judgment. It's better to outline your goals ahead of time.

Third... review your investments at least once a year – preferably every six months. Make sure the reasons you bought remain valid.

There's no single rule that will tell you when to sell... That's because there's no rule that tells you when to buy.

The strategy for selling is determined by why you bought in the first place – and should be determined at the time of your initial investment.

When you buy, it's critical to know exactly what you expect to get out of the investment and what would lead you to sell...

The easiest way is to set a simple stop loss or trailing stop loss. Both of these will help you control your emotions when an investment works against you.

With a simple stop loss, you set a fixed point at which you'd sell... essentially setting the maximum amount you're willing to lose if you're wrong on an investment. So for example, if you buy a stock at $100 per share, set a 20% stop loss, and it falls to $80 per share... you'd sell no matter what.

The principal criticism of this kind of stop is that you've only committed to selling at a loss... Theoretically, your investment could rack up huge paper gains, and you could give them all back if the stock fell all the way to your fixed stop loss.

Trailing stops address that problem. They're an easy-to-understand way to eliminate your emotions and get out of losing positions before they get too large... or take profits when your paper gains get too large.

With a trailing stop loss, you raise your selling price every time the stock hits a new high. Say you buy a stock at $50 per share and set the trailing stop at 20%. If the stock price falls straight down, you'll sell at $40 per share. But if it rises to $80 per share, you'll sell on a decline back to $64 (20% below the high of $80). That way, you've protected yourself and pocketed a 28% gain.

You can also use fundamental analysis to determine when you might sell a stock. For example, you might sell when the shares become overvalued relative to the company's earnings or cash flow and compared with other potential investments.

Or you can do what I do... Create a sell level on a chart by marking an expected return one year out and then using that as the technical trigger.

Say I buy a stock at $100 per share. If my plan is to make 12% on my initial investment per year, I'll mark $112 and $124 on the chart. If in one or two years the stock hasn't traded above those levels, I'd sell. This sort of technical analysis can also incorporate moving averages or price support and resistance levels to guide you. (I don't use this much for selling, but I do when buying.)

However you determine your sell prices, it's important to write things down. This teaches you discipline. It helps illustrate when investments are working out and when they aren't. That way, when it's clear they aren't working the way you envisioned, you can change things.

One trick I use to make sure I remain disciplined is to ask myself whether I'd buy more of the position right now, or if I would recommend it to friends or family. If the answer is no, it's probably time to sell.

Also, if I'm really worried I'm making a mistake about selling... I remind myself that I can always open a new position after a 30- or 60-day break. There's nothing magical about the time frame. It just serves as a cooling-off period for my emotions. Most likely, a good investment will still be attractive at that point. In many cases, I've found better opportunities by then.

When you're selling, there's no room for emotions.

Let's say stocks are trading at record highs – and stops don't apply. When should you take your money off the table?

The key is to be aware of the power of your feelings. When emotions are involved, buying investments is easy. Selling is much harder...

With most people, psychology usually works against your investments. So I'm going to show you a few pitfalls to be aware of when thinking about selling stocks.

Imagine this simple scenario... Say you own two stocks. You bought each at $50 per share. Over the course of your investment, one has risen to $75 per share. The other has fallen to $25 per share.

Suddenly, you and your spouse decide you need to raise money for something immediately. Perhaps a car you've wanted is on sale at the local dealer... or a cabin on a lake where you want to retire is suddenly on the market. You need to raise some cash... so you decide to sell one of your investments.

But which stock do you sell?

If you're like most people, you choose to "capture" your gains... You sell the $75 winner and keep holding the $25 loser. You may think the loser stock seems to have more upside potential, and you've probably been waiting to "get even" on the position...

It's a nearly universal impulse... But it's a terrible investing choice.

People love to sell their winners too soon and ride their losers too long. A slew of behavioral finance studies shows it. One study by University of California, Berkeley Professor Terrance Odean found investors are almost twice as likely (1.7 times) to sell a winning stock as they are to sell a losing stock.

Following similar logic (or urges, really), investors held losing stocks for 124 days and unloaded their winning stocks after 102 days.

You may say, "Maybe the winning stock had grown overvalued, and its gains were behind it."

It turns out, the winning stocks (which had been sold) subsequently outperformed the losing ones (which investors were still holding).

It depends on what time frame you look at. But the general consensus is that in six- to eight-month periods, stocks that are moving up tend to keep moving up, and stocks that are falling tend to keep falling. It's a phenomenon called "autocorrelation."

This confirms the old adage: "Let your winners run and cut your losers short."

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig

Editor's note: Everything Doc has done over the past four decades has been leading up to this moment. You see, the biggest threat to the U.S. retirement system is on the horizon... But you don't have to be a victim. On July 19 at 10 a.m. Eastern time, Doc is sitting down on camera to explain what's going on and how to prepare for it – including why it's creating a historic buying opportunity in one of the most "bulletproof" parts of the market.

Don't miss this critical online event... Click here to learn how to attend for free.