When it's time to sell a stock

@FortuneMagazine August 22, 2011: 1:31 PM ET
How to know when it's time to sell a stock

FORTUNE -- Deciding when to get rid of a stock has always been tough. These days, though, it can be outright nerve-racking. Stocks have been on fire -- the S&P 500 index has doubled from its bear market low in March 2009 -- and as a result, you're probably sitting on at least a few stocks that have experienced major runs over the past two years.

But there's a growing chorus of doubt about how long this bull market can last. Here, then, some guidelines for helping you decide whether it's time to take some profits off the table.

1. Forget what you paid

Fixating on the price of your initial investment only hampers your ability to make a rational decision. The relevant question is, Would you buy the stock at today's price? If the answer is yes, don't feel compelled to sell -- even if it's had a big run.

Consider one of Warren Buffett's recent buying decisions. In March, Buffett's Berkshire Hathaway (BRKA, Fortune 500) said that it was acquiring chemical maker Lubrizol for $9.7 billion. The deal made headlines when Berkshire executive David Sokol resigned after admitting he bought Lubrizol's stock before pitching it to Buffett. Less publicized was Buffett's willingness to buy Lubrizol even though the stock had soared 340% over the previous two years -- more than triple the gain of the S&P 500 (SPX). Not only was Buffett unfazed by the run-up, but he was willing to pay a 28% premium on top of it. Why? Lubrizol's shares were trading for only about 12 times estimated 2011 profits when Buffett pulled the trigger -- cheap compared with many of its peers.

2. Do a reality check

Remember that a company's fortunes can transform radically while you own the stock -- and your reasons for buying may no longer be valid. Have customers altered their spending habits? Have new competitors entered the fray? Has your undervalued gem become the darling of investors? That last question is particularly crucial for fast-growing companies that trade largely on expectations of future performance -- once the stock has run up, there's little margin for error.

For instance, if you had bought shares of trendy sportswear retailerLululemon Athletica (LULU) two years ago, you'd be sitting on a 600% gain. That rise has been fueled by impressive sales growth. But the company gave a lower growth outlook for its current quarter, and competitors like Nike (NKE, Fortune 500) and Adidas are now gunning for its upscale customers. At a recent price of $98, Lululemon's stock was trading at 48 times expected 2011 earnings, far above its peers' average price/earnings ratio of 17. Expectations have been raised.

3. Plan ahead

Plotting your sell strategy in advance "is a good way to remove emotion from the process," says Tom Forester of the Forester Value Fund (FVALX). Even if you feel it's time to unload a hot stock, actually taking that step can sometimes prove difficult. It's hard not to think about the gains you'll miss if it keeps rising. So consider a stop order, which instructs your broker to sell if the stock slips to a predetermined level -- say, the price at which you'd lock in 90% of your current gain. You get to keep the upside, and if the stock drops you'll still keep most of your profits.

Finally, consider the tax benefits if you're mulling the sale of a stock that's on the rise but still trading for less than you paid. If you do sell, your loss can be applied against your capital gains -- and if you have no gains, or if your losses exceed your gains, you can deduct up to $3,000 of the losses against your ordinary income. Any capital losses that still remain can be carried forward indefinitely.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.  To top of page

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