Typically, our approach to deciding when to sell is driven by fundamentals, usually when a company is underperforming our expectations or experiences some problems that put its future prospects in jeopardy. Individual investors tend to delay deciding to sell these companies in the (usually futile) hopes that they just might, if given enough time, return to their former glory.

In truth, our brains are wired to procrastinate making tough sell decisions because it delays the pain that comes from acknowledging a poor choice. If we sweep the stock under the rug, we can fool ourselves into forgetting about the company—at least until the next brokerage statement arrives.

The other kind of sell decision—selling a stock that has performed well—is also difficult, but for different reasons. Selling a solid performer from your portfolio, a stock that has earned respectable returns, means that you’re eliminating the potential of all future returns from that stock. Selling a portion of such a holding is also a surefire recipe to create regret, either because it will likely turn out that you should have sold all of the stock or none of the stock.

But stocks never grow in price linearly. With our longer-term approach, we rely on earnings to drive price appreciation. The market, however, often has other expectations about how a stock “should” perform in the near-term. Traders may look at other non-fundamental factors in order to make their buy and sell decisions, introducing volatility and uncertainty to our well-selected stock picks. Emotion-driven investors, both amateurs and professionals, make decisions that drive stock prices to both stratospheric and suboceanic levels.  It is only over the long-term that stock valuations and prices converge and reflect the “true” value of a company.

This disconnect is apparent both in the depths of a bear market and the irrational exuberance of a bull market. In the latter, for stocks that have grown significantly in price since purchase, it can be a wise move to sell (or replace) stocks that:

1. Are selling at more than 150% of their average P/E ratio (their relative value is greater than 150%).
2. Have a reward-to-risk ratio less than 1:1.
3. Have an expected total return approaching the yields available from long-term government bonds.

An option instead of selling a highly appreciated stock is to use a trailing stop-loss order (TSLO). This order instructs your broker to sell the stock if its price falls more than the percentage you’ve designated from its high price. What’s useful about a TSLO is that the stop price keeps resetting as the stock goes up in price. For long-term investors, a trailing stop of between 5% and 10% is often suitable. Note that once the stop is triggered, the order is filled at the market, so the execution price in a fast-moving market could be well below the stop price. A TSLO can provide good insurance from a sharp and sudden market drop or the inevitable retrenchment of a stock that’s advanced beyond a fundamentally sustainable price.

Always keep in mind your personal capital gains tax situation when deciding to sell on overvaluation. In a tax-advantaged retirement account, where there is little or no downside to capturing gains on a regular basis, you might be quicker to sell than in a taxable account.

- DOUGLAS GERLACH