#9 Investing 101: When Should You Sell?
You shouldn't sell except three situations.
I used to advise my friend on investing.
I would tell him all the stocks I had, yet my portfolio would largely outperform his every quarter. For a long time, I thought he wasn’t actually buying what I had told him. I was wrong, I only understood the real reason last March.
I told him to buy AMD in December 2023. The stock was trading at just above $60 back then. A few months later, in early March 2024, the stock broke above $200.
I told him “I think this is getting outrageous right now, I am selling it and I think you should too.”
What do you think he told me? “I already sold it for $110.”
“You little motherfucker,” I thought, “at least you could have told me!”
I finally knew why he was underperforming: He was selling too early!
Luckily, after reading this, you will never say “Oops! I sold too early again..”
Let’s get started!
Investing is a two-stop game.
Most people confuse this point and they think they will be all set once they buy the right stock.
It couldn’t be far from the truth!
Buying the right business at the right time sets you up for a profitable ride but you only realize those profits when you sell.
However, when to sell is even harder to understand than when to buy because people mostly disregard the risks that come with selling.
Most people think the buying is when you assume the risk and selling is when you leave that risk. It’s totally false. Selling opens you up to three risks:
The stock you sold may keep outperforming.
The stock you bought instead may underperform.
You may not find anything else to buy and your money could erode.
It’s inherently riskier than buying.
This is why selling should be an exception.
This is the absolute first thing to understand. When their positions go up, people think that they have to start considering exit. That’s an absolute bullshit strategy that would open you up to risks.
Great investors are default buyers, selling is an exception.
Why? Because seeing exceptions is freaking easy.
If the market is trading at 28 times forward earnings, you can’t comfortably say it’s a bubble.
It may be, it may not be.
But if it’s trading at 60 times earnings, you could call the bubble with some damn confidence.
So, you are probably asking now: What are the exceptional situations to sell?
There are three.
1️⃣ Sell When It Is Freakishly Overvalued
This may look obvious but what most people think is “severe overvaluation” doesn’t warrant selling a great company.
We are talking about something way bigger here.
Just assume that you successfully executed the first part of the investing operation, meaning:
You picked a great company with a strong, competitive advantage.
You bought a large position.
You didn’t overpay for it.
Now remember the basics of this operation, why are we buying an exceptional company?
Because we believe that an exceptional company will consistently grow its earnings in the future and the stock price will increase with earnings.
This provides us a favorable position at the time we buy. Available scenarios are:
Stock is overvalued.
Stock is undervalued.
Stock is fairly valued.
In normal circumstances, every company is a great investment at a cheap enough price. Great companies, however, are great investments also at a fair price.
So the assumption is that if it was undervalued, the market will correct it and then it’ll keep growing, making us money. If it was fairly valued, we will keep making money as it grows its earnings.
Earnings increase 20%, stock price increases 20%, it’s all good, still fairly valued.
However, when stock price increases 25% against 20% earnings growth, it starts to eat from next year’s growth projection to remain fairly valued.
Here is an example: Assume that the stock will grow earnings 20% consistently and so it will be valued at 20 PE.
What happens if the market values it at 100 times earnings?
It has to grow earnings 20% for the next 9 years so it’ll be valued fairly at 20 times earnings in the year 10 if the stock price doesn’t change at all.
The market has already priced in the next 9 years and gave it to you.
There are only two ways for you to keep making more money than the market is offering you right now:
The business will do something exceptionally valuable.
Market will keep overvaluing the stock.
You can’t bet on any of them. You can’t know. Both scenarios are too speculative.
This is why you should sell when it gets freakishly overvalued. There is no money left to be made.
So, why aren’t we selling when it gets a bit overvalued? The reasoning is the same.
Yes but amazing businesses tend to surprise upward.
Take American-Express as an example. This is an exceptional business that was founded in 1850 and keeps compounding 174 years later.
Look at its earnings growth:
This company tends to grow earnings 10% annually thanks to its amazing moat. In 2021, it was trading about 30 times earnings. You could say this was expensive. But look what happened next: It grew earnings 20% from 2023 to 2024. It surprised upside.
It can do even 25%, 40% and maybe even 50% in an exceptional year. This is why I am not selling it when it gets moderately overvalued. But damn I know it won’t triple the earnings in a year so I’ll be definitely selling it if it’s valued at 100 times earnings.
You get it?
Not just overvalued, freakishly overvalued.
2️⃣ Sell When The Fundamentals Are Broken
This should be your base case scenario for selling.
Most of the time stocks you hold won’t get too overvalued that warrants an immediate exit.
What generally will happen is that the reasons you bought them in the first place start to fade away slowly. When that happens, it’s time to walk away and look out for new opportunities.
Take the example we used above: American Express.
In normal conditions, the company posts around 10% earnings growth annually.
A part of this is attributable to inflation because inflation increases basket totals for consumers and thus the size of American Express’ commission also grows. Rest of it is organic growth. More people start using American Express and more merchants accept it as a payment method.
As a result, you get a long term earnings growth like this:
Set aside inflation and think about what are the fundamental drivers of its organic growth?
It should be simple:
It makes more money if more people use its cards.
It makes more money by charging more fees for its cards.
Look how its average card fee grew over years:
This gives you a clear clue: If you see that its card fees stop growing, this means that the customers started to think it’s not worth it to pay for it.
If you observe this two times in a row, you will know that a fundamental value driver of the business is broken and it might be the time to consider selling.
It may not be this obvious all the time though.
You can’t just observe the revenues and consider selling when the revenue growth obviously slows down. Everybody will notice it and most people will sell before you. You will get slaughtered.
So, here is a tip: Always observe the gross margin.
Gross margin is basically how much premium a company charges on its costs. A company with a competitive advantage would usually optimize this number and won’t cut it down if it doesn’t feel any external pressure to do so.
If the gross margin trends down, this usually means two things:
Business is losing to competition.
Consumers don’t want what it sells as much as they used to.
Both break fundamentals in the medium to long term. This is where you get your early signal: When the gross margin decisively trends down, be extra careful and think about selling.
3️⃣ Sell When There Is A Greater Opportunity
Among all reasons to sell, this will be the one that you will most often see and also the one that you should take most exceptionally.
The reason is simple: Every decision brings a new risk in investing.
Just look at how many things you have to get right to successfully pull off this scenario:
You should successfully spot a better opportunity.
You should sell the position that has the least upside potential.
The new stock you bought should outperform the old by a large margin.
These are not easy things to pull off.
To start with, everyone thinks the businesses they don’t own are more attractive. This isn’t true most of the time. People are like this, they see somebody who owns Palantir that went up 250% year-to-date and think they should sell their American Express and buy Palantir.
They just ignore that the person they envy might have bought Palantir at $7. The risk/reward has become significantly unfavorable since. We just tend to ignore that.
Whenever you think there is a superior opportunity, remember what Peter Lynch says:
Your default position should be adding on your existing ones.
Now, even if we assume that you have spotted a company that’s really good, you have to also decide which position to sell. You want to sell the one with the least upside potential.
How easy to do this? It’s not.
Selling a position and seeing it go vertical just after you sell is one of the most painful things you can experience in investing. It’s hard.
Even if you pull that off though, it doesn’t end.
Your new position should outperform your old one by a significant margin. The keyword here is “significant.”
Why? It’s easy.
If you have gone through all these steps assuming additional risk at every step just for a 4% incremental return, you made a very unwise decision in terms of risk/reward. It should outperform by at least 15% so you will look back and say “it was worth it.” Otherwise you just took a stupid risk and got lucky.
Here is an example of a perfect scenario to sell under this title:
You own UnitedHealth stock and don’t own Amazon stock.
Inflation goes off the roof and the Fed starts to raise interest rates.
Investors get panicked and sell Amazon, hammering it down for some 50%.
In this case, it actually makes sense to sell your UnitedHealth position and buy Amazon.
You won’t see Amazon getting halved just for macro reasons too often. On the other hand, UnitedHealth is a defensive stock. People will always need healthcare and prioritize it. It won’t go down much when the Fed hikes rates but it also won’t go much higher.
By selling your UnitedHealth position you can capitalize on Amazon opportunity and also still keep the chance to remake your UnitedHealth position at attractive prices as it won’t also skyrocket when the rates are going up.
🏁 Conclusion
Investing, by definition, is a long-term operation.
Your default position should be holding the exceptional businesses you have as long as you can so they can compound and make money for you.
Selling should be an exception.
There are three cases of this exception, ranked from the least to most exceptional:
The business is losing its edge.
Stock got freakishly overvalued.
You need money for a superior idea.
When you were to sell something, always remember that every action in investing exposes you to a new set of risks. Thus, for every action, there should be an adequate promise of return. Otherwise you are just losing to your urges to trade.
Investing is smartest when it’s most business-like and I don’t know any successful businessman who jumps in and out of new businesses daily.
Keep that in mind!
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