I am frequently asked if an investor should sell a stock after it drops a given amount from the price paid. I know many people believe in using stop losses and/or simply can’t stand the pain of the price falling on something they own. But a value investor should never sell a stock because the price has fallen.
If the price falls because something has fundamentally changed then you should revaluate whether the investment is a good value at the current price. If not, then you would want to sell. If nothing has fundamentally changed why would you want to sell simply because it was “on sale”? You should consider buying more not less!
Price Paid and Rebalancing
Here is an illustration of the thought process for the decision to buy or sell a stock with portfolio rebalancing added. Let’s say you have Asset A, (for this example it will be a basket of stocks that will do well if we have rising inflation), and Asset B (for this example it will be a basket of stocks that will do well if we have falling inflation). If an investor believes the probability of each outcome is 50/50 he may choose to put 50% of his portfolio in Asset A and 50% in Asset B. Let’s say rising inflation causes the value of Asset A to double and Asset B to fall 50%. Now Asset A is 2/3 of his portfolio and Asset B is 1/3 of his portfolio.
Should you sell some of Asset A or some of Asset B? Sorry, this was a trick question, because; the investor first needs to assess the probability of the outcomes before rebalancing his portfolio. Let’s say he again feels that there is a 50% chance of inflation rising and 50% chance of inflation falling. In this case he would need to sell some of Asset A (which had doubled) and buy more of Asset B (which is priced 50% less than the original purchase).
When the fundamental or intrinsic value of an asset has not changed; rebalancing forces you to buy more of assets that are bargains and own less of assets that are expensive. Rebalancing is a superior investment concept to using stop-loss orders.
Buying and Selling a Stock
Mentally prepare yourself for buying and selling a stock like you would consumer items. When something of value is on sale you would be apt to buy more not less! Think of investing the same way. Investors should lower asset allocations to investments that are expensive and increase asset allocations to assets that sell far below their real valuation.
When analyzing my portfolio I look at each individual asset and ask myself; is the current price an excellent value? If not, I will sell it. If so, I maintain my position and consider buying more anytime the price drops. Once you own an asset the price paid should not enter into your buying and selling decisions. When selling a stock, it’s the value and price today that matters!
Related Reading: Selling Stock at a Loss and Loss Aversion Bias