We love growth stocks. Throughout the years, we’ve uncovered dozens that have doubled or more (in some instances, much more) in a relatively short period of time; some of these winners literally made our entire years, helping lead our portfolios to terrific gains. One thing all these growth stocks have in common is, at some point, we’ve had to sell.
The recent increase in volatility and the number of shares hitting new lows (especially among growth titles) makes now as good a time as ever to reiterate an important lesson.
No matter how good a stock has been to you, it’s vital to remember one absolute truth—all leading stocks are going to top. Most investors fall into the trap of thinking that, because earnings are cruising higher and the story remains good, their stock is insulated from forming a long-lasting top. That is not the case.
In fact, it’s just the opposite. Bill O’Neil of Investor’s Business Daily has written that, once a big leading stock tops, its average decline to its final bottom is 72%! In our decades of growth investing experience we’ve seen it happen time and again; when a growth stock goes bad, it really hits the skids. That’s why it’s vital for you to heed a stock’s message, and never fall in love. You need to know when to sell your stocks.
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What Makes a Growth Stock a Sell?
On the way up, high-performing growth companies have great stories with big sales and earnings growth that propel their stocks higher. And, importantly, they will continue to have great stories and growth numbers even after they top. Translation: If you’re holding on to a former winner while its share price drops because “it’s a great company, and business is still good,” you need to find another reason. You need to know when to sell the stock.
Why do these drops happen? Because the stocks become over-owned; after a year or two of advancing at a great clip, and with many great quarterly reports under their belts, the stocks have been bought by hundreds of mutual, pension and hedge funds. At some point, no matter how good a firm’s growth, some of these institutions decide when to sell stocks or trim their position, which can top out the stock. And remember, these funds take a long time to build and unload positions, so when the top is in, it takes months before the selling subsides.
We’re not writing this to scare you or depress you; too many investors look at the selling of a big growth stock as a sad cutting of ties, an action that kills any hope that they’ll make more money from the stock. Really, though, it’s just part of the process—just as in any sport, sometimes it’s time for defense, other times, offense. Knowing when to sell stocks is part of the game.
Why Selling Stocks is Smart
There’s one final reason to be on guard with former leaders: When a new bull market begins, there will be dozens of great growth investing opportunities … but only if you’re not tied up (both monetarily and emotionally) with the old leaders! Thus, it’s best to have room in your portfolio for new and potentially huge winners when the tide turns back up.
As a growth investor, you’ve developed a plan for identifying potential buying opportunities. It’s important to use those same metrics to determine when to sell a stock that’s not performing as expected. If you’re using technical analysis and your buy signals have flipped to sell, exit the position and reassess the trade. If your strategy was sound, but the trade didn’t work out because of market conditions or unexpected news, you’ll still have some dry powder to make your next buy. At the same time, when a trade is moving in your favor, plan an exit strategy in advance. You won’t want to sell a stock that’s surging higher, so an upper price limit is probably not ideal, but using stop-loss orders to capture profit, or setting mental stops (points at which you’ll sell if a trade turns around) can be a great way to minimize loss or keep profits.
The most important point to remember is this: even the best growth stocks don’t stay growth stocks forever. At some point, the equity markets are pricing in the growth of the company fairly. At that point, as a growth investor, your opportunities for further appreciations have begun to evaporate, and you need to look elsewhere for your next trade.
What’s your personal rule for exiting a profitable position?
*This post has been updated from a previously published version.