The second leg of investing- When to sell, what to sell

(This appears in the print edition of Deccan Chronicle, yesterday/today)

Investing is a ceaselessly tiring subject. We do not have set answers because even if we follow a rigorous process in choosing stocks, there is the market behaviour which puts paid to all our grand plan.

To accommodate Mr Market (as Benjamin Graham would say) we have to factor in the entire spectrum of human emotion from greed to fear. These factors, drive the prices and the demand-supply for equities. And these factors are equally applicable to individual as well as institutional investors. A small percentage of people try and keep aloof and capitalise on Mr Market. They use the opportunities provided by Mr Market, to buy and sell.

We sometimes have a definite plan when investing in equities. We would like a reasonable target return rate (say an annual compounded rate of fifteen percent) over a fifteen or twenty year period. Let us say, we fix the term as twenty years. We either will not need the money and will pass on our collection of stocks to our successors or we would like to cash it.

Should we foresee a need to cash out, then it is important that we take in to account Mr Market. We cannot plan very precisely that at the expiry of, say, twenty years, the market price will precisely give us our desired return. If I have a twenty year horizon, I should be ready with my selling orders from year fifteen or sixteen. If my return rate is exceeded by then, I would like to cash out and keep the money in liquid funds or in bank deposit. There is no gurantee that the markets climb up precisely at a particular rate each year. It is possible that there could be some scam or crisis which hits the market on the day we want to sell. Prudence demands that selling is a well planned out thing. We cannot leave it for the eleventh hour.

I generally take a ‘target price’ approach. I keep a conservative target. For example, if I am looking at a fifteen percent compounded return over twenty years, on a share I buy at Rs.100/-, the selling target price is approximately Rs. 1450 per share. If the investing company has done as I expected, then the only worry I have is on Mr Market. It is possible that this target price could be hit even in fifteen years. In any ten year cycle, it is reasonable to expect two to three instances of optimism and two to three instances of gloom. Excesses always happen on both sides. So, I am ready to sell my stock anytime after year fifteen if the price target is achieved. If my price target is achieved in just five years, then obviously my assumption is very conservative.

If we have a large portfolio of some share/s, then we may like to time our selling in phases. We may start selling at or above our target price and keep selling in small lots till we exhaust our selling. The objective should be to protect our target selling price and not give in to greed to keep hoping that the markets will never correct or that our stock will stand out. Mr Market can waylay the best of plans.

The same philosophy should be followed whether we are doing an SIP or block investing. There are many situations where we may plan an expenditure because our investments have done well. In such situations, it would help if we plan the sale. Choosing what stock to sell would probably depend on how concentrated your portfolio is. For example, it is possible that in a passive portfolio, one or two stocks could form over fifty percent of the total market value. It is debatable as to which ones to sell. Here, I like to fall back on my thesis of using the P/E Bands as my friend.

I sell those stocks that are the closest to the “high” of the historical P/E band. For example, if two stocks have a historical high P/E of 40, I would sell that stock which is closer to 40. In a sense I respect valuation plus the market. I try and sell that stock, from which the potential future return is lower in comparison. I use this same principle if there is a need for an unplanned selling also. When there is an emergency and I have to sell some stocks, using historical P/E Band is a useful tool.

Buying stocks is an easier thing. What to sell and when to sell deserves more careful thought. Selling a share locks in your returns for real. Selling thus assumes importance.