You've read the balance sheet, studied the fundamentals and done a thorough job of researching the company. You're ready to buy.
But you shouldn't -- not until you've done some thinking about when you're going to sell. Believe it or not, that's every bit as important as deciding when to buy. Until you close the trade, after all, you really haven't made any money. (Just ask the IRS.)
So when you consider your investment goals -- which should be realistic, time-based and easily measured -- you must also devise an exit strategy that lays out your loss threshold and your target price. Do this in advance. Remember, investing can be stressful and emotional, and sometimes amid the glee of victory or the agony of defeat it's easy to make a mistake. In these cases, even a bad plan is better than no plan at all!
Think of the loss threshold as the worst-case scenario. The tricky part is deciding what's a reasonable downside. Reasonable upside, for its part, is pretty easy to judge. After all, the long-term return for the S&P 500 is 12%. For a market-neutral loss threshold, an investor might take the opposite of the historical norm and decide to hold on up to or until she hits -12% in losses. If the investment has a higher risk profile, you might need to be willing to ride out bigger losses; if it's risk profile is very small a conservative investor might move into cash after a very small loss. The point is to have a plan. All investors know to have goals, but many forget to cover the other option and consider what they'll do if the market moves in the other direction.
The good news is that there are only a limited number of outcomes. A stock can generate a loss, a gain, or find itself locked in a holding pattern. The bad news, however, is that this is the art of investing. There aren't any hard and fast rules, only broad guidelines.
Let's address losses first. When an investment loses value -- and most will from time to time -- the first question should be why. Say you own shares in a major drug maker and its shares drop 10% in a week. What caused the sell-off? It could be major company news, such as an earnings miss, a product recall or an experimental drug failing a clinical trial. It could also be the ripple effect of an industry development, such as new Medicare pricing rules that could eat into drug companies' bottom lines. Or it could be contagion -- bad news affecting a Competitor A doesn't always help Competitor B, sometimes it hurts. The key determination an investor must make is whether whatever caused the shares to fall is temporary. If you decide it is, then there's no reason to sell the shares. Nothing that can reasonably be called a temporary problem should change the fundamental reason you bought the stock. (In these cases, buying more sounds like a better course of action than selling.)
But sometimes things are worse for a company or a sector -- it's not temporary bad news but a catastrophic business failure. When this is the case, it is better to back up your things and look for alternative investments.
Occasionally stocks fare poorly because the market is faring poorly. In these situations, you should sell potentially problematic shares as soon as you make the determination that problems are afoot, regardless of your loss-threshold price. Many times, healthy companies will sink with the rest of the market for no fundamental reason. Things change, and investors have to be vigilant: proactive when possible, reactive when necessary.
If you don't think things are all that bad -- and you have a reason rather than a hunch -- then it's perfectly fine to hang on, and, just as in our previous examples, it might even be wise to consider buying more shares to lower your overall cost basis. But in most cases, the best course of action is to sell your stocks when they hit your loss threshold. Don't let hope be the only reason your holding on to a stock. Put the proceeds into a safer instrument that will help make up for the loss and rebuild your portfolio's value.
So what do you do with a laggard? Say you're in a sector ETF that you thought was going to take off, and it hasn't. If the catalyst you thought was going to move things in your direction hasn't happened, then hang on. But if it has and the effect wasn't what you had anticipated, then it's time to get out.
Because an investment that sits still costs you money. The economy grows, the value of each dollar shrinks a little over time and every month that those dollars languish in some sluggard of a investment is a month they could have been in a high-yield bond fund earning 7%. Nothing is free in this world, not even time. Flat performance in one sector of your portfolio can be every bit as damaging as a loss and could mean the difference between hitting your goals and not.
And, finally, how about the view from the finish line. If you picked a stock that moved like you wanted to and met your goal, then congratulations. The two options are to determine if a new goal is warranted or if the stock has served its purpose.
You see, winning stocks are really problematic. After they've made their initial gain, investors tend to become attached to them. Easy to see why: A successful stock buy is proof positive that you won a round in the toughest game on earth. But as I mentioned above, there's a real and significant cost to keeping those laggards on the payroll. Bottom line: Don't grow attached to your investments. They're financial tools, not pets or loved ones. It's OK to kick them to the curb after they've served their purpose.