Knowing when to sell stocks is one of the most difficult aspects of investing. While there is no shortage of advice on buying strategies (whether value, growth or momentum), there's a lot less written by those in the know about how investors can apply some logic to their selling decisions. Even the great and prolific Benjamin Graham seems to have been fairly quiet on the subject, other than a brief reference to selling after a price increase of 50% or after two calendar years, whichever comes first. As a result, many investors simply don’t have a plan in place to preserve capital and/or lock in profits. Instead, they are often swayed by fear of loss or regret, rather than by rational decisions designed to optimise their returns.
Fighting Loss Aversion
Studies show that, when making money on a trade, people often take profits early to lock in the gain but, when losing money on a trade, most people choose to take the "risky" option by running losses and holding the stock. Unfortunately, good investors usually do the exact opposite - they cut their losses and run their profits! The explanation for our generally irrational behaviour relates to "loss aversion", i.e. the fact that people actually value gains and losses differently. Behavioural studies have shown that losses have more emotional impact than gains and are weighted more heavily in our decision-making (some studies suggest that losses are twice as powerful, psychologically, vs. gains).
To counteract this tendency, one option is to adopt a mechanical selling strategy based on strict rules (i.e. a system of stop losses). One interesting mechanical approach is set out by American fund manager William O'Neill of Investors' Business Daily (IBD) as part of the CAN-SLIM method advocated in his best-selling book, "How to Make Money in Stocks". As O'Neill is a growth/momentum-focused investor, his system makes most sense in that context but there are some general principles that are certainly of wider interest.
Cut your losers
First of all, O'Neill notes that losses are inevitable for any investor and must be faced up to - "the first rule for the highly successful individual investor is . . . always cut short and limit every single loss". However, he notes that, to do this, takes never-ending discipline and courage. He cites Bernard Baruch, a famous Wall Street operator…