Sell Discipline for Investors: Importance and Execution

Investors usually don't have an aversion to buying an asset. The real gut wrenching decision is when - and if - to sell. What most don't realize (or don't want to realize) is the overwhelming importance of the sell decision. Let's explore the reasons why and the techniques that can calm a seller's nerves.

Finding reasons not to sell an asset is as easy as finding a reason to avoid a root canal. Have you ever heard (or told yourself), "I can't sell now, it's too low!" or, "The analyst at XYZ brokerage says the price is going through the roof!" or, "I don't want to pay the capital gains tax!"

Let's look at each of these "justifications" in the context of their impact on an investment portfolio and techniques to avoid having to come up with them:

"I can't sell now, it's too low!"

If an asset's price has fallen dramatically, there is usually a fundamental problem. Often, that fundamental problem then becomes a technical problem. In other words, as market participants see dramatic declines in price charts, panic sets in and the "heard" starts to chase the price down even more (reference the NASDAQ Index from February of 2000 to September of 2002). Once an asset has been trampled, it is extremely difficult and time consuming to resuscitate.

Sell technique: First of all, don't let prices fall "too low". Set a predetermined point to sell if the asset price drops and stick to it. Execute a stop loss order so discipline is not an issue. Note - selecting a selling point doesn't have to be complicated process. Either determine where your "pain threshold" is in terms of market value or percentage losses and mark that point. Or look at a historical price chart and look for "floors", which are price points where the price seems to repeatedly bounce back up. If the price falls below that point, it's often a point of no return.

If you continue to "like" the security even though the price has declined, determine a price to repurchase the asset AFTER a positive price trend has developed. Finding the absolute price bottom is like trying to catch a falling knife. Use a "buy stop" order to make sure you purchase the security at your predetermined point.

"The analyst at XYZ brokerage says the price is going through the roof!"

We have observed numerous cases in which Wall Street analysts have been penalized for lining their pockets, or those of their firm, by producing biased research articles designed to impact prices in their favor. Analyst hype can only take a security to a point, after which it must stand on its own merits. Investors beware!

Avoidance technique: Let's assume that analyst Rich Buyhype is right and the asset advances upward. First of all, let's follow the previous technique and execute a stop loss order. Then, if the asset appreciates in price, periodically move the stop loss price up proportionately with the price increase. This is known as a "trailing stop". Most brokerages will allow their investors to change their stop losses easily without a charge.

"I don't want to pay the capital gains tax!"

An overwhelming amount of stock investors would have loved to have paid capital gains taxes in 1999. Most would have paid considerably less than they ended up losing in market value over the next 2 years. Keep in mind the capital gains tax applies only to the amount of the gain, not the value of the asset. A 15% capital gains tax payment is less than a 15% loss in market value, unless the asset has no cost basis.

Avoidance technique: Unfortunately we can't avoid paying taxes on realized gains. But we can sell assets and avoid losses greater than the tax paid. Don't let the tax tail wag the investment dog. If an asset hits your stop point, sell it and don't look back, whether it's at a gain or a loss. After all, unless the tax law changes, you'll have to pay gains on the sale at some point.

Summary

Selling a security to lock in your profits can be a very useful strategy, but it is sometimes difficult to execute. If you don't have the discipline to sell at a predetermined point (most investors don't), set a stop loss order so the trade will happen automatically. Use the trailing stop loss technique if your asset is appreciating to lock in your gains. These strategies work especially well in situations where capital gains taxes aren't an issue. However, keep in mind the many of the wealthiest investors pay substantial taxes because they identify the right points to lock in profits and avoid large losses.

Please visit our website at www.limestone-capital.com to learn more about sell discipline and active investing.

Rob Hounshell is President and Chief Investment Strategist of Limestone Capital, a registered investment advisory. He holds the Chartered Financial Analyst and Certified Financial Planner designations. He has been managing investments for 18 years.