Stuart Shaw, CFA

A discipline for selling stocks is just as important as having a disciplined approach to buying stocks. Sometimes it is difficult to admit a mistake, watching the price of a stock drop while continuing to justify a decision to hold on. Don’t keep justifying holding a stock gone bad. Be disciplined about selling. Here are some red flags to watch for:

The company’s business has changed dramatically from what you originally purchased, thereby making a key reason for buying the stock in the first place no longer valid. This is particularly so if management is moving into businesses that are entirely foreign to the principal business, and beyond management’s expertise. Also, approach mega-mergers with extreme caution, e.g. Time Warner and AOL. Different cultures can clash. Integrating companies cuts into management’s time needed to run the business. Expected benefits from synergies are usually overblown. Moreover, just the uncertainty of the outcome could hurt the stock.

Management is consistently selling large amounts of stock. When I’ve asked management why, the reason given has always been the need to diversify for estate planning purposes. Don’t believe it. Knowing what’s going on with their company, management would not be selling if they believed in the value of the stock. Management’s personal financial interests should be aligned with you, the shareholder. If they are not, why should you continue to hold a stock that management is unloading?

The Street loves this stock. You picked a winner, and now every analyst following the stock is recommending purchase. Institutions own the vast majority of the outstanding shares. The stock’s Street sponsorship is at a peak, and buying power has been used up. The company must deliver results that live up to investor expectations. Investor sentiment is so positive that any change has to be negative. Another way to observe this is when the stock price stops going up on good news. The stock is fully discounting all the positives. In other words, there is no more upside momentum left, and the trend could be about to reverse.

The company reported earnings (or pre-warned about upcoming earnings) that were disappointing versus consensus estimates. Something is going wrong. The odds of another earnings disappointment are high as one earnings disappointment usually leads to another. Also, be on the watch for a forecast from management of future problems, which may even come along with an excellent earnings report. Do not look for excuses in order to justify the negative surprise.

Is a recent purchase down 10%? You just bought a stock and the price is dropping. But there is no news to account for the decline. The stock may be telling you that there is a problem up ahead. Always assume that something may be going wrong and protect your capital. Do not let the price fall more than 10%. At that point sell, cut your losses and move on. I once observed a securities analyst at a prestigious investment firm continuing to recommend purchase of a stock all the way down to bankruptcy. He just kept stubbornly justifying his position. Don’t let your ego get in the way of being able to make successful investment decisions.

The stock is overpriced. Recognizing attractive company fundamentals at a great value, you picked another winner. Now it’s time to see if this stock is still value priced. Always value and revalue your stocks. When a stock becomes overvalued on whatever valuation method you use, there is no compelling reason to continue to hold it.

Your portfolio has performed well, and you are feeling very confident and comfortable. These strong emotions could be reflecting a market top, and you may be putting your money at the highest risk of losing it. Read and listen to what’s going on around you. Is exuberance running rampant? Is the stock market’s ”new golden era” being splashed on magazine covers? When you and everyone around you feel that nothing can go wrong, it’s time to sell.

It’s time to rebalance your portfolio. Stocks should be equally dollar weighted as possible in order to build a balanced and diversified portfolio. When the dollar values of a stock or stocks become significantly outsized relative to other stocks in your portfolio, harvest some of these gains. You will be protecting your capital and bringing the stocks in your portfolio back into better balance.