If you're a buy-and-hold investor, it's easy to push the topic of selling aside. After all, if you're investing well, you'll hopefully rarely be selling.
That being said, it's important to understand when you should sell a stock, even if the scenarios are few and far between.
Reason No. 1: You were wrong
This one is the hardest to come to terms with. But being wrong about a thesis for a company from time to time is just part of the process of investing. Being able to recognize your erroneous thesis early is key to mitigating any losses you might incur.
This is why having a written thesis is important. When I was a new investor, I came up with reasons why I liked a certain company but often failed to take the time to document them. Years later, I found myself questioning why I had bought the stock in the first place. On more than one occasion, I sold it for a loss due to my lack of conviction.
If you put pen to paper (or more likely, fingers to keyboard) and write out your thesis for why you're bullish on the company, it will be easy to revisit during times of turmoil to see if your original thesis is still on track or completely busted.
Reason No. 2: The stock hit its ceiling
One of the most important numbers to estimate when you're researching a potential investment is the market-cap ceiling for the company. The market cap is the total value of all the company's outstanding shares, and the ceiling is your estimated pinnacle of growth for a company's market cap. In simpler terms, if Company A has a market cap of $1 billion and it's addressable market is $5 billion, the ceiling represents how much of that addressable market you believe company A can capture.
Take Upstart Holdings (NASDAQ: UPST) for example. The lending-software company saw its stock shoot up from $44 at its IPO to nearly $400 less than a year later. That's a 784% return in less than 12 months!
The unsecured personal-loan market is about a $144 billion industry. While Upstart is disrupting that industry with its artificial intelligence (AI)-based alternative to underwriting, in 2021, the stock market had priced in a nearly 25% market share for Upstart at a market cap of $33 billion. At that price, it's hard to see significant upside for the business, even if it executes perfectly.
Of course, hindsight is 20/20, but this example highlights the importance of having a rough estimation of the ceiling in case the stock gets way ahead of itself, like Upstart did. If the stock exceeds your ceiling price, you should either recalculate your ceiling (due to unforeseen optionality) or seriously consider exiting or at least trimming your position.
One reason you might reestimate your ceiling is if the company has expanded into a new markets or developed new products since developing your thesis. This is called optionality.
If you're invested in growth companies, you should revisit your ceilings regularly. High-growth businesses are dynamic and often part of the bull case is the company's optionality. Amazon is a great example of a company that most investors likely would not have dreamed of achieving a trillion-dollar market cap back in the late 1990's.
Yet, if you had stayed current with the business throughout its growth story, you would have recognized the incredible new markets and products it continually introduced (Amazon Web Services, the entertainment business, logistics, etc.) and adjusted the ceiling accordingly.
Reason No. 3: You need the money for something important
We all have our reasons for investing. Those goals might include things like buying a house, paying for your kid's college tuition, helping out family, or even starting a business.
While ideally you should try to save up for these expenditures outside of your stock portfolio, life doesn't always work on our timeline, and selling stocks to pursue really important things can make sense on occasion.
If you do sell for this reason, have a system in place. If you're someone that doesn't like to see single positions grow too concentrated, consider trimming some of your winners.
If, on the other hand, you like to run your portfolio concentrated in your highest convictions, consider selling your lowest conviction holdings.
A really bad reason to sell
Perhaps the worst reason to sell a stock is simply because it's going down. Unfortunately, the pressure from social media and the financial news to do this is strong when the market is crashing.
The price of admission to the greatest wealth building machine in the world — the U.S. stock market — is enduring corrections from time to time. That doesn't mean you should never sell a stock if it's crashing; you just shouldn't do it solely because it's crashing.
It's perfectly plausible that there is a thesis-busting development in the business that's causing the price to crater, in which case selling may make sense. But as we've witnessed in this current macro-fueled bear market, stock prices can very easily become disconnected from the underlying business. And for patient, long-term investors, that usually spells opportunity.
Conclusion: Have a good reason to sell
Just like you wouldn't buy a stock without doing your due diligence, you shouldn't sell one without having a really strong reason to do so. There are certainly other legitimate reasons investors might sell stocks besides the ones listed above (like to lower your capital gains tax bill), but long-term investors need to establish a well-researched justification before selling.
Once you've come to terms with that reality, you'll find the best decision is usually to do nothing.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Mark Blank has positions in Upstart Holdings, Inc. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and Upstart Holdings, Inc. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.