Here is the rule:
If you invest directly in the share market you should always know why you are invested in a particular stock and at what price you would be willing to sell that stock
Know why you are invested in a stock
Knowing why you are invested in a stock is very different to knowing why you invested in a stock in the first place.
Last year I wrote a piece on Reasons and Tips to stay on top of your existing investments and it is as true today as when I wrote it. That post argued that we are programmed to care about things that are:
- Exiting (i.e. new investment opportunities)
- Painful (i.e. investments that are going very badly)
However all to often we don't really care about those investments that hadn't done anything. The companies could have changed substantially along with their risk profile and the opportunities associated with it however we do nothing because in an investment sense they have not done anything to cause us to turn our attention to them.
Having an investment thesis for every one of your stocks improves your investment portfolio as a whole. Not only are you protecting your downside in looking out for things that could demolish value but you also have more opportunity (and more funds) to invest in opportunities with greater upside.
When I wrote the article above a year ago I was committed to cleaning up my portfolio and getting rid of all of those stocks which were not performing. Although I started to do this I certainly haven't done it to the degree that I need to and I'm still holding some stocks where I don't understand the company at all.
Know at what price you would be willing to sell
All stocks have a value. Sometimes they are overvalued and sometimes they are undervalued and the only thing that we are sure of as investors is that we will never know what the right value is and whether it is overvalued or undervalued.
But you need to have a view
It doesn't need to be perfect and it doesn't have to be a single number. As long as you believe that "the share price should be somewhere in this range" then you will have a value at which you would be willing to buy the stock and you would be willing to sell the stock. The less certainty you have the bigger the discount you would need to buy the stock and the bigger the premium would need to be for you to sell the stock.
Not having a view on value is a recipe for disaster. You will never know if you should sell a stock that is going down or buy one that is going up. You may sell into winners and buy into losers. This doesn't mean you will be right every time...but it should, over time reduce the number of bad decisions that you make.
Knowing what price you would be willing to sell at can help avoid a common investment bias
Last year I also wrote a post about Knowing Your Investment Bias. It covered knowing what traits you had as a person which would limit you as an investor.
A common investment bias that investors have (and which I have in spades) is the unwillingness and inability to sell stocks. We do this for a variety of reasons. Personally I like to have another investment to put my cash into when I sell a stock. I don't want to simply put it in cash as I almost view this as a negative investment. Objectively I know this is crazy but I seem to do it over and over again.
Knowing what price you would be willing to sell a stock at can help you overcome this bias. I don't want to own a stock that is overvalued as I don't want to lose money. I would rather crystalise the gain and then have the impetus to find another investment.
So what do you do next?
Unlike most investment dilemmas this one has some pretty clear next steps...however they are time consuming. I will be going through each of these steps myself:
- Evaluate every single stock in your portfolio - know why you have it and what you think fair value is (accounting for a range and uncertainties)
- Sell every stock that looks overvalued or you can't get your head around. Don't worry if the stock price goes up. You'll feel much more pain if it goes down once you think it's overvalued.
- Keep an eye on your other investments on a regular basis to make sure you aren't missing any opportunities
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