When Should You Sell a Stock for Profit: Top 5 Reasons - The Average Joe


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    When Should You Sell a Stock for Profit: Top 5 Reasons


    August 5, 2021

    when should you sell a stock for profit

    Most investors spend a lot of time picking the right stocks but  have little on understanding when to sell a stock for profit. Instead, they’ll watch their companies oscillate up and down — only to see their paper profits disappear. Ultimately, when investors are curious about when should you sell a stock, it always comes down to the same answer — it depends. Well, here’s what it depends on…

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    Among advice from professional investors, you’ll often receive two conflicting thoughts when wondering when to sell a stock for profit:

    • Many advocates holding for the long-term and that most investors miss out on the majority of gains by selling too soon
    • While others advocate cutting your losses — but what happens when one of your long-term holdings swings up and down?

    How do you know when to sell a stock for profit when these thoughts contradict?

    Ultimately, it comes down to your investment style and developing a set of rules for yourself. If you’re a long-term investor that holds a stock for several years or decades, there may be certain instances when you need to sell.

    The following act as guidelines and should act as complex rules on when and how to sell a stock for profit.

    Content: When Should You Sell a Stock for Profit?

    The William O’Neil Rule For Selling Stocks

    William O’Neil, one of the all-time investing greats, developed a rule for selling shared through his book, How to Make Money in Stocks.

    • The Rule: Sell a stock if it moves up 20% from its breakout point
    • The Exception: if the stock moved up more than 20% in less than 8 weeks and if it does, analyze the stock further
    • Also: Cut your losses at 8%

    The benefit of this strategy is that you could be wrong twice and right once, and your portfolio will be fine. Your capital will be used more efficiently, avoiding unproductive corrections (i.e. a stock falling and trading sideways for an extended period).

    According to O’Neil, the following are signals on when to sell a stock for profit:

    • If a stock runs up too quickly within 2-3 weeks, this could indicate a climax top activity
    • When it becomes “obvious” that the stock is going to go higher
    • If its quarterly earnings growth slows materially or earnings actually decline for two consecutive quarters
    • If the stock moves up but other companies in the same sector aren’t seeing similar strength

    when should you sell a stock for profit

    When to Sell a Stock for Profit: Selling for Better Opportunities

    Unless you’re selling for retirement or making a big purchase, this should be the biggest reason to sell a stock.

    Another all-time investment great, Warren Buffett, says the best reason to sell a stock is to find something you like much better. He rarely sells, but when he does, he’ll sell his east likes stock at the current price — the one he feels the least sure of in where it’s going to be in 10 years.

    This thought is shared among other fund managers like Dennis Lynch, Head of Counterpoint Global at Morgan Stanley Investment Management. He’ll sell a stock when the risk-reward ratio is no longer as compelling as other ideas.

    Here are some tips for finding better investment opportunities:

    • As an investor, you should be building a watchlist of companies you’re interested in — constantly evaluating which opportunities are the best at their current prices.
    • Stock prices are prone to fluctuate and you’ll often find a better entry price to buy a stock

    When to Sell a Stock for Profit: Selling if a Stock Gets Too Expensive

    The market can act irrationally in some cases, and stocks can rise significantly in days or even hours. Stocks can jump irrationally for many reasons — overreaction on the news, insider trading or even as simple as retail investors piling into meme stocks.

    Similar to William O’Neil’s advice in the earlier section, if a stock makes a big move in a short period (a few weeks), it’s often a good signal of the best time to sell a stock for profit.

    But it’s important to understand what’s driving the movement behind the stock before deciding to sell a stock for profit. Ask yourself these questions:

    • Is the stock moving up based on fundamentals (i.e. strong earnings growth, company development)? If not, then it may be time to consider selling.
    • What is the company’s current valuation relative to its competitors? If it trades at a significant premium to others with little justification, it may be time to consider selling.

    Most of these moves are often unsustainable and the stock will often fall lower after the market realizes the stock is overextended.

    When to Sell a Stock for Profit: Selling to Diversify Your Portfolio

    When building your portfolio, you should aim to set rules for yourself, such as limiting your positions to a maximum percentage of your portfolio.

    If a stock rises and grows to become a large portion of your portfolio, then it might be time to consider selling a portion of the position to bring it down below your maximum allocation.

    • The allocation is based on your personal investment preferences which as an example, can be 5-10% depending on the number of positions in your portfolio.
    • i.e. if you’re looking to hold 10 stocks, set a limit for each position to be 10% with minor deviances.

    This is a crucial point in determining when you should sell a stock for profit as you don’t want your risk level to be too exposed to a single stock.

    When to Sell a Stock for Profit: Selling When an Investment Goes South

    Most people refuse to sell a stock based on a misconception that “it’s not a loss until you sell.” But this is wrong, and it’s already a loss even if you don’t sell.

    If you’re holding on to a loser, you’re only occupying money that could be invested in a different opportunity — relating to the first point of selling for better opportunities.

    One of the most common investment advice given by fund managers is to cut your losses. But knowing when a trade takes a wrong turn is the hard part — which often takes experience to learn.

    Market momentum is a significant factor in a stock’s movement, and without it, stocks can often trade sideways for a long time or, worse, trend downwards. Many things can lead to a shift in market momentum:

    • Slowing growth: Slowing growth in sales or earnings could impact a company’s momentum in the short term.
    • Regulations: A change in regulations could really kickstart or halt the growth of an industry (i.e. cannabis/sports betting legalization or banning of e-cigarettes).
    • Industry disruption: A competitor could come into the market with a better product (i.e. e-commerce companies disrupting physical retail).
    • Economic conditions: Changes in government policies could impact an entire sector or an entire country’s stocks.

    Another reason is that the stock may have simply gone up too much, too fast — running out of buyers. The market ultimately consists of buyers and sellers, and stock will struggle to move up without enough buyers. So when should you sell a stock for profit – when you find a better opportunity.

    When to Sell a Stock for Profit: Selling to Lock In a Capital Tax Loss

    Another reason to sell is to use your loss to reduce taxes on regular income or capital gains — known as tax-loss harvesting. Locking in a capital tax loss involves selling an investment below its book value, thereby making the investor realize a loss on their investment. 

    The investor can deduct this amount in their tax calculation to reduce the taxes paid. Investors often use this tactic near the end of the year to minimize taxes. But this strategy only applies to taxable accounts. Non-taxable accounts like IRA and 401(k)s do not qualify for tax-loss harvesting.

    Bottom Line: When Should You Sell a Stock for Profit?

    Of course, the exception to these rules is on potential mega winners — the stocks that can turn into your 100 baggers over time (i.e. the Amazon’s and Netflix’s of the world). But identifying these mega winners is another lesson. Subscribe to our stocks and investing newsletter for future lessons, tips and advice on how to invest in the stock market.

    There’s no one size fits all solution when it comes to investing in a stock, and even the best professional investors make mistakes. The difference in what makes them successful is managing their losers and finding a set of rules that fits their investment styles.

    Even a professional investor will often have a 50% hit rate (i.e. investments that go up) — but what separates a good and bad investor is how they deal with losses. With proper selling techniques, you too could sell a stock for profit before the proverbial sh*t hits the fan.

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