The ways of love are vastly different from the ways of investing, of course, with emotion being central to the former and potentially toxic for the latter. Save your emotions for matters of the heart, and always remember that investing is a matter of the mind that calls for as much objectivity as we can muster. I love a good hot bowl of Campbell's Tomato Soup, I eat one serving of some Kellogg's cereal (usually while watching my Sony television) almost every day, and my next automobile may very well be a Ford SUV. But I don't own any of those stocks, because they don't make the grade based on my (relatively) objective criteria. I have seen investors grow so attached to particular stocks that any suggestion of selling them is received as if I were proposing the sale of their first-born child. Right from the start, we need to be on guard as to how our emotions might be influencing our investment decisions. Mr. Spock would have made a great investment adviser.
To develop some sort of exit strategy for our holdings we need to go back and consider the reasons why we bought a stock in the first place. The goal of equity investing is to make money, but more specifically our goal is to outperform the broader market. We can achieve market returns by buying an index fund or an ETF, but effective stock-picking is supposed to lead us to the best returns, something far greater than what throwing darts at the stock tables would yield. As an example, let's say we bought shares of XYZ stock at $20 based on our analysis that the company's earnings prospects should make it worth $30, a 50% return if things work out. Then XYZ reports a couple of really good quarters of earnings results, taking the stock right up to our $30 target price. Do we sell? Maybe, but maybe not. If the earnings have been better than what the analyst community expected, that probably means that our $30 target was too conservative from the start. In that case we should be adjusting our target price to factor in the company's improving earnings outlook, and that is exactly what you'll see with the analysts' target prices. Just recently, Visa (V, $113) reported better-than-expected earnings and offered some details about mobile payments and chip technology that may replace the magnetic strips on their debit and credit cards. (Remember, V is not a financial company that takes credit risks; it is a technology company that processes transactions, something like a toll collector.) V had been trading around $100 with price targets in the $110 range, but after the report analysts increased their target prices to the $120-$130 range. Here it is probably best to hang on and enjoy the ride. Imagine if you had bought Apple (AAPL, $495) at $200 and sold after it rose 50% to your target price of $300. You don't want to collect a bunch of bruises from kicking yourself.
"Nobody ever went broke taking profits" is an old Wall Street maxim that gets no argument from me, but there are numerous ways to pursue profit-taking. If we have a self-imposed rule that says we're going to sell any stock that appreciates by, say, 20%, then we have just guaranteed that our total return will be somewhat less than 20%. That is because we'll have some stocks that do much worse, and we need long-term winners to offset the weaker returns in our portfolio.This is what is known as "letting your winners run." Isn't our goal here to find those stocks that continue to outperform over very long periods of time? Of course it is, and that makes portfolio management something of a culling process. Over time we need to get rid of the stocks that aren't living up to our expectations and keep the ones that are still exceeding those expectations--and find more stocks in the latter category. This is one of those nice problems to have, but we also don't want our really big winners to become too heavily weighted in our portfolio--remember, diversification is one of our bedrock principles. If we have a stock that doubles, we might want to consider selling half of the position--we can book some of our profits and then play with "The House's Money."
Right about now you're probably thinking that all of this sounds great if we have winners, but what about the losers? Time for another metaphor. Buying a stock is not unlike hiring someone for a job, as both processes involve certain expectations, based on a job description, and the failure to live up to those expectations consistently means that we hired the wrong candidate. Sometimes we have to put on our Donald Trump persona and say, "You're Fired!" But what about the money we invested in training that deadbeat? Here it really shouldn't matter whether the stock shows a gain or a loss, because what really counts is future performance. Essentially, if the reasons (expectations) for buying the stock in the first place no longer hold true, we need to move on. If your fiancee tells you a week before the wedding that she has decided she must have six kids instead of the two you had mutually agreed upon--and that her mother needs to come live with you, also contrary to mutual understanding--then you might need to pick up the phone and call the caterer before the real damage can be done. So, if we bought XYZ stock expecting stellar sales growth from a new product, and that sales growth just doesn't happen, we need to cut our losses and find a better stock. The money we have to invest is a scarce resource, and it does not need to be sitting in a stock where hope is the only evidence of a turnaround.
Some investors will use a "stop-loss" order as a way of limiting their losses when a stock declines. If you buy a stock for $25 with a stop-loss of $20, this means that the stock will automatically be sold if it falls to that level. I don't use stop-loss orders and am really not a fan of them at all, for one key reason. When the market takes a major plunge, the good stocks tend to go down along with the average and bad ones, and I don't want my stocks to be sold in a broad market selling panic. When a stock just follows the market down, that is known as a decline for "non-company-specific" reasons. This is very different from a stock that sells off based on unfavorable news that is specific to that company. I actually like to buy my favorite stocks in major market sell-offs if the investment story is still intact. I do think it is important to follow the price action of our stocks under different market scenarios. For example, I would consider it a warning signal if the market was consistently moving higher and XYZ stock was consistently not participating. Even in the absence of specific news about XYZ, I'm going to suspect that someone knows something that I don't. If such under-performance continues, I may have to conclude that XYZ is not doing the job I hired it to do. Please note, though, that we shouldn't reach these conclusions based on trading action over one or two days. Stocks that have run up may see some profit-taking even if the market is advancing, so we have to allow for that.
I'll wrap up here with a few caveats. Those who adhere strictly to a value investing approach will take issue with what I have said. They would argue that if you find a stock that is undervalued, you should stick with it through good news and bad, and buy more of it if it goes down. Then sell it when it is fully valued. I can't argue with that, but I am focused on growth, and I try to invest in companies whose growth prospects have not been fully understood and fully valued by the market. Warren Buffet once said that his holding period was "forever," but as much as I would like my holdings to be a "'til death do us part" arrangement, I'm not going to stick with a stock once the earnings growth has slowed--and especially not if that growth fails to materialize. I actually have all the patience in the world as long as my stocks are doing what I hired them to do.
Happy Valentine's Day! And, as the great Al Green sings, Let's Stay Together.......
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If you'd like to spend Valentine's Day curled up with your significant other (your partner, not your favorite ticker symbol) for a good romantic movie, I suggest Love Actually (2003). My wife and I discovered this movie over Christmas, and I can't believe I had never seen it. If I want to pull my wife away from her Hallmark Channel fare, I have to find a movie that we both can enjoy--a romance that is a cut above a "chick flick." This one is worth your time.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of V and AAPL. Stocks are mentioned here for the sole purpose of illustrating investments concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.
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