If you use the buy and hold value investing strategy, you will avoid several common investing mistakes. Your portfolio won't suffer from the churn of day trades, you'll minimize transaction fees, and the tax implications are far lower than they would be otherwise.
You'll eventually run into a conundrum—a point of disagreement between the investing strategies of Benjamin Graham and Warren Buffett. The question is this: when should you sell a stock? Here are a few answers.
Sell When The Prices Reaches the Intrinsic Value
Benjamin Graham's strategy was to exploit inefficiencies in the market. If a stock is underpriced relative to its intrinsic value and if you have a respectable margin of safety, sell when the stock's price reaches the business's intrinsic value.
Graham argues that, in the long run, the stock price of a good company will reflect the intrinsic value.
This strategy has its advantages: it's a consistent rule, easy to understand, and it gives you a countercyclical view of stock performance. Buy low, sell high.
In the meantime, if the company's earnings are mediocre, you'll get mediocre results. Selling at the intrinsic value doesn't necessarily account for the long term health of the underlying business. The business has to have sufficiently predictable earnings for you to make discounted cash flow projections, but predictable earnings don't make a company spectacular. This strategy also forces you to take a long view. The company could meander through undervalued prices for several years before you can realize the fair prices you calculated. (Yet that's true of all stocks.)
For the best results with the Graham approach, you must dig into the quality of the company. How good is it? How consistent is it? Does its business model hold up throughout the business cycle? You'll have more difficulty finding a bargain stock on the S&P 500 than a small-cap, but bigger businesses tend to have more stable business models and management. That's no guarantee, but the risk profile changes with the size and age of the company.
Hold a Great Company Forever
Warren Buffett modified Graham's strategy to be a little pickier. He retained Graham's approach of using intrinsic value and discounted earnings calculations to decide a fair price to pay for a stock, but he went a step further. Buffett calculates the amount of money a business can produce every year to determine a projected rate of return. By retaining the stock and not selling it, he has a rule of thumb estimate about the real rate of return of the value of his investment.
This approach also relies on high quality businesses. It's not enough to find an undervalued company which will eventually meet its price goal. You need a Coca-Cola or Exxon which invests in its business every year to return more and more money to its stockholders.
If you pay a fair price for a great business, why sell it? If it's giving you good annual returns, hold it! Reportedly, Buffett looks for a 15% annual return after taxes and inflation. That's aggressive—he can achieve that by negotiating favorable terms because he's Warren Buffett—but it can be done.
Hold Until a Better Opportunity Arises
A hybrid approach looks for great opportunities but invests in good ones as they come up. Buy the best stocks you can at the moment, but be willing to sell them when something better appears. With this strategy, you have your eye on a few good possibilities. You keep running the intrinsic value analysis as things change. You bias your selections to solid companies you wouldn't mind holding forever, but you weigh future opportunities against your current holdings. In the case of a so-called market correction (when stocks go on sale), you may have an opportunity to exit one position so as to enter a more favorable position elsewhere.
This approach has more churn than the Buffett model. You'll pay more commissions and need to manage your taxes a little more aggressively than if you bought and held forever. Yet you're also not buying and selling every week or month or even every year. On the other hand, you can calculate the point at which it's worth trading for a better position in a better company. (Besides, it's worth keeping at least some money, perhaps quarterly dividends, in a highly liquid investment so that you can take advantage of these opportunities as they appear.)
When to Sell a Stock
Obviously these strategies apply only when you have the luxury of investing patiently. Sometimes you have no choice, but ideally you have your personal finances in order such that your investments can wait out the daily fluctuations of the market and let compound growth take over.
If you can find a great stock at a good price and buy and hold it forever, fantastic! Otherwise, look for good opportunities and don't let inaction keep you from missing out on good returns. There are fewer tax and fee complications with the index fund investing strategy, and you don't have to balance your portfolio or investigate individual stocks. On the other hand, you can pursue a better return than the annual 8% of the S&P 500 index over time. Buffett's 15% is possible, with time, effort, and research.
Investing in stocks is complicated enough without trying to find a single mechanical strategy which fits every situation adequately. If you control your own investments, the decision when to buy and sell is yours and yours alone. Learning how other successful investors have approached the subject will give you information; it's up to you to put it into practice with your own portfolio.
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