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When itís time to sell, consider using a stop-loss order ó also called a stop market order (see Chapter 5). You can place a stop-loss order to sell when a certain price is reached. Its purpose is to limit your loss on a particular security. For example, you can set a stop-loss order for 10 percent below what you bought the stock for to limit your loss to 10 percent. For investors who are unable to watch their portfolios for an extended period of time because of holidays, vacations, and so on, this order can be a tremendously useful tool.
A sure way to lose big money is to hang on to an investment thatís losing money. Try not to involve yourself emotionally with your investment selections. One way to lower the likelihood of holding on to an investment for too long is to develop a few personal selling rules. Write your personal selling rules in your investment plan and store the plan on your computerís hard drive. If youíre thinking about selling an investment, use these rules to compare your current state of mind with what has worked for you in the past. Your personal selling rules may state, for example, that you should sell the stock if any of the conditions in the following sections occur.
The stock drops below your predetermined trading range
This selling technique is called scaling out. In other words, it is a structured selling method based on your predetermined trading range. For example, you can sell stock at predetermined levels as it goes up, say 20 to 25 percent of your investment at a time, securing profits along the way. Each time you sell 20 to 25 percent, the average cost of the stock remaining decreases, protecting you from the effects of a sudden possible decrease in the price of the stock. Some industry experts suggest selling any stock that increases by 30 percent above the original purchase price. In contrast, sell the stock if it drops below 10 percent of the purchase price.
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Before you sell it, however, remember why you purchased the stock in the first place; then find out what changed and how it affects your portfolio. In the past, maybe the company was a market leader or the company had a new technology. Perform a post-sale analysis of the stocks that plan you sell. Determine the best time for selling by examining the tax consequences of your actions. For more about how you can avoid profit wipes-outs due to capital gains taxes, see the last section of this chapter.
You discover that the companyís relative strength is flat or trending downward
Relative strength is how the company compares with the market or operates in the current market environment. (When researching, you often discover the relative strength number calculated for you.) Check out the relative strength of the stockís performance over the latest 12-month period. Compare this number with other stocksí numbers to determine whether your stock is a loser. Low relative strength ratings are often the first red flags for sell candidates. The rating scale is between 1 (lowest) and 99 (highest). Stocks rating 70 or lower may be laggards and potential sell candidates.
You recognize that the industry is in a serious downturn
To recognize a downturn, you must watch the company, the industry, and the sector rather than just the stock price. Management changes can also adversely affect stock prices. Sell the stock if the company shows signs that it may not produce the earnings or sales growth you originally expected when you purchased the stock.
You determine that the company is in decline
Even great companies are cyclical ó that is, they have up periods and down periods. Sometimes you can purchase shares at bargain prices, and other times you buy shares that are overpriced. In general, all companies are affected by the economy and have selling cycles. Some stocks trade with a low P/E ratio even if the company is earning money. These low P/E ratios indicate that investors fear the companyís earnings will decline. These fears, which may be
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based on new competition in the marketplace, can also adversely affect earnings growth and long-term prosperity. For example, does the company rely on one single product whose life cycle or patent may be running out? If so, consider selling this stock and replacing it with a similar stock that has more promise.
You discover that the companyís profitability or financial health is in trouble
If profit margins and the financial structure of the company seem to be weakening, you should consider selling. That is, sell if the stock shows below-average profitability compared with the industry standard or other selling standards based on the firmís financial statement. For example, determine whether the stock has three years of earnings that are up 25 percent or more and a return on equity ratio (ROE) of 17 percent or more. Use a selling standard that meets your required rate of return. If the stock doesnít meet your standards, sell it.