How to Know When It’s Time to Part Ways With a Stock

Selling a stock can be emotional and nerve-racking. You fear losing money in a downturn, but also fear missing out on potential gains. For heavy traders, the decision isn’t so hard. One of my favorite mutual fund managers, a notoriously short-term investor, says that he never buys into a company without being able to see the day and conditions under which he will sell it.

“Luckily,” he adds, “that means I have to look no further ahead than tomorrow.”

Most individual investors have been following a “buy and hold” strategy--buy good companies and stay with them for the long haul. The stocks they purchase become a part of their portfolio for months, years or decades.

Nonetheless, with the market having dived in recent days and experts nervous about the onset of a downturn, some individual investors naturally wonder if this is the time to sell.

It is far from a cut-and-dried decision.

Consider this excerpt from a letter written by a reader in Framingham, Mass., one of literally dozens of similar notes I have received since January. “I know that the stock was a good purchase,” he writes. “I just don’t know whether it is still a good stock to own.”

In the excitement of a sudden downturn, investors can easily ignore the original reasons they bought the stock.

“People aren’t questioning the fortunes of a particular stock so much as they are wondering whether to be in the market at its current levels,” says John Markese, president of the Chicago-based American Assn. of Individual Investors. “Some people have a hard time determining whether what they really fear is the long-term future of the stock, or the short-term future of the stock market.

“If they sell based on short-term emotions, they break their strategy,” he said. If they ignore a long-term plan, they may be making “a deadly move.”

So if you are trying not to pay too much attention to the overall market, how does an investor decide whether it’s the right time to sell a particular stock? Let me count the ways. If more than three apply to your holdings, it’s time to reevaluate your portfolio:

* The story that attracted you to the stock has changed.

Experts agree that one of the best things an investor can do before buying a stock is to write down their reasons for making the purchase. Sometimes, you find out this way that the motivation is a bit flimsy.

If you don’t have an inventory of your reasons, try to reconstruct it. Clearly, there was something about the stock that was appealing--perhaps its product or service, history of dividends, sound management or earnings growth.

If those elements have changed--say you bet on a pharmaceutical stock developing a revolutionary product and the government has stepped in to halt the medicine’s development--then listen to your head. Your heart may tell you that a turnaround is coming, but intuitively you know that things may not be the same for a long time.

* You are holding on to get back to break even.

If your only reason for hanging onto a stock is to avoid taking a loss (or to avoid having to pay capital gains taxes, for that matter), you have lost sight of the key issue. Would you buy the stock today?

If all you want to do is return to the initial price you paid--as opposed to hanging on to reach the goals you set when purchasing the stock--you have already made the decision to sell.

Stocks do not come with any guarantee of returning to break even. If you would not come to the same conclusion about a stock today that you drew when you purchased it, there is not much reason to hang on.

* The stock fails to meet your expectations.

If you are reviewing your portfolio and you find a stock that has been consistently disappointing, dig deeper to see whether it still has the chance to perform or whether you simply thought more of the stock than it was worth.

You should also set downside limits, how much of a loss you are willing to endure. A number of professional money managers sell any stock that falls 15% to 20%. These limits become “negative expectations” and help you make an unemotional sell decision when one of your investments becomes a disappointment.

* The stock has met your expectations.

One major difference between professional investors and the masses is that the money managers are much more ruthless and unemotional in trading stocks. They try to evaluate how much a stock will rise in price and reevaluate the stock’s prospects once that level is met.

This is where you can get into sophisticated analysis, setting targets on everything from price-earnings ratio to how the P/E ratio relates to company growth.

Some growth investors, for example, look for companies where the price-earnings ratio is lower than the rate of growth in company earnings; the minute profit growth dips below the P/E, they see it as a sell signal.

* Your time horizon has changed.

The stock market is a strange beast. A company with solid long-term prospects has one period where its earnings fall short of analysts’ expectations, and its stock price gets bludgeoned for a year. Conversely, a stock shows the slightest upward potential and it often holds momentum for months.

If you remain a long-term investor, riding out the bumps and hiccups makes sense, so long as you expect a rebound.

Conversely, if you have evolved into a short-term investor or have a more immediate need for the money, short-term concerns have a bigger role in your decision-making process.

* You have lost faith.

“Once you discover that the stock is outside your sphere of confidence, that you no longer believe in it, everything else is secondary,” says Boston investment counsel Arthur C. Clarke. “In times like this when you are bombarded with market noise, you don’t want to make a hasty decision, but if you have stopped believing in a stock, you don’t need to look at anything else because you have made the decision.”

Charles A. Jaffe is personal finance columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.