Here’s How to Decide When It’s Time to Sell an Investment

Article content

By Julie Cazzin with Felix Narhi

Q: Some of my security investments in my registered and unregistered accounts have increased in value. I have a hard time knowing when to sell. Can you provide me with a checklist to help me decide whether to sell or hold? –Myles

Article content

FP answers: Making a decision to sell is often one of the most difficult decisions for investors. There may be personal reasons for accepting a loss of capital or, in a fortunate case, securing a profit. These may include tax considerations, estate planning, or simply the financial need to repay a loan or make a large purchase.

Article content

A significant amount of investment advice focuses on when to buy stocks, but there is strikingly little reference to the equally important aspect, when to sell. This oversight is quite strange considering that every transaction involves both a buyer and a seller and the timing of a sale is a crucial factor in an investor’s return.

Article content

Ultimately, an investor’s return is the sum of dividends received and the difference between the buying and selling prices over the duration of the investment. A lack of effective selling strategies can undermine even the efforts of investors who are best at finding undervalued stocks.

A successful sale requires discipline and the use of the same tools and processes that were used to purchase the asset. Human psychology plays an important role in a sales decision. Unfortunately, emotional decision making is a common trigger for “buy high, sell low” behavior. If you don’t have a solid thesis or a complete rational understanding of why you bought the security in the first place, you probably don’t know what has changed that should make you consider selling.

Article content

Article content

Investing is about more than just following a checklist or analyzing quantitative data. it is a mix of art and science. No investor, no matter how smart, will make the perfect buying or selling decision 100 percent of the time. The goal is to be mostly right most of the time. To achieve this, an investor must be aware of three situations in which it may be time to sell: overvaluation, a better opportunity, or a miscalculation.

A security is overvalued when the market believes the company is more valuable than the underlying data suggests. Overvalued securities may remain overvalued for a while, but markets eventually correct. There are some signs you should look out for. When it comes to overvalued securities, there is usually a lot of good news and high expectations already anchored in the price, and high hurdles need to be overcome. If these companies disappoint investors, their prices could fall quickly and the investor could suffer a loss.

Sometimes a security remains a good investment, but the market offers an even more attractive alternative option. Stock prices are constantly changing, so it makes sense to add value to your portfolio whenever possible. In this case, it may make sense to sell part or all of a current holding to acquire one with potentially better prospects.

Article content

There are also times when the original purchase thesis of the security turns out to be no longer true. For example, market leadership can change quickly when industries become disruptive in times of rapid technological change. No investment is a “set it and forget it” investment. Investors need to stay abreast of company developments and industry news. Times are changing and so are business prospects.

You also mentioned that you have assets that have increased in both your registered and unregistered accounts. In the search for higher returns, investors may overlook their true goal: making the most money after taxes.

Depending on the type of account in which you hold your securities, differences in tax rates and timing will be important. For example, capital gains in a Registered Retirement Savings Plan (RRSP) are not taxed when triggered, but ultimately the entire capital is taxed at the highest marginal rate when it is ultimately withdrawn. Capital gains on non-registered accounts, on the other hand, are taxed at a more favorable rate but are credited in the year of withdrawal.

Article content

Here’s the secret: Once you master the discipline of when to sell, you should still be more active with your RRSP and more patient with your non-registered accounts. Many investors tend to do the opposite.

Use the tax system

A key to increasing real wealth is understanding how to take advantage of the tax system. This can be achieved by focusing primarily on investments that are taxed at lower rates, such as capital gains, and delaying the payment of taxes where possible.

Fortunately, the maxim “sooner or later” when it comes to taxing capital gains on unregistered accounts is usually left to the individual investor. All things being equal, choose “later.”

Paradoxically, the investment with the lower pre-tax return sometimes results in greater after-tax wealth because the deferred tax liability continues to increase in your favor until it is triggered.

A true long-term investor should think of deferred taxes as essentially an interest-free loan from the government. Unlike regular debt, investors benefit from having more assets working for them, but they have no monthly payments, are not charged interest expenses, and can decide when the bill is due. In other words, tax deferred offers all the benefits of regular leverage without the drawbacks of debt.

Article content

As long as investors continue to hold on to an investment, they are effectively working with free money that would disappear if they decided to move in and out of other stocks. We believe this hidden but very real form of leverage is a key reason why wealthy people and successful portfolio managers shy away from selling successful holdings in great companies just to buy something else, something cheaper.

To achieve long-term success, individual investors must remain disciplined and develop a better understanding of the emotional and cognitive biases that could influence their decision to sell. It is also important to recognize that mistakes are occasionally made along the investment journey. The key is to learn from them to do better next time.

Felix Narhi is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management Ltd.

Article content