Although a basic objective for common stock investors is to buy at a lower price than they sell, they should realize that at least some of the stocks that they purchase will probably need to be sold at a loss. Failing to cut losses is one of the common mistakes investors make. Another common mistake is taking profits too quickly.

According to an article in The Wall Street Journal (7-24-91), too often, investors sell their winners and keep their losers. The article then stated, “That’s the worst thing an investor can do.” The article went on to advise, “Decide on some sensible ‘sell rules’. . . and stick with them. Over time, investors who follow a disciplined selling strategy will be better off than those who try to decide emotionally on each stock case by case. . . .”

We will discuss four strategies that can be helpful in deciding when to buy or sell stocks.

1. Fundamental reasons: When the long-term business or economic outlook that led you to purchase a particular company’s stock is no longer valid, consider selling the stock. On the other hand, if the deterioration in the prospects for the company is likely to be only temporary, it may be prudent to exercise patience and continue holding the stock.

2. Formula methods:

a. Dollar-cost averaging: A constant dollar amount is invested at regular periodic intervals, such as every month or every three months, and is usually invested in the same stock or the same group of stocks each time. Since the constant dollar amount of each purchase results in acquiring more shares at low prices than at high prices, investors can generally expect to acquire stocks at a favorable average price.

The following example illustrates how dollar-cost averaging works:

Time

Period

Amount

Invested

Cost

Per Share

Theoretical

Number

of Shares*

Actual

Number

of Shares

Actual

Cost

of Shares

1

$1,000 $ 40 25.00 25 $1,000

2

$1,000 $42 23.81 23

$966

3

$1,000 $41 24.39 24

$984

4

$1,000 $44 22.73 22

$968

Total 94

$3,918

* Amount Invested divided by Cost Per Share

The average cost per share in this example is $41.68 ($3,918 divided by 94 shares).

b. Constant ratio: This method is used to manage a portfolio that includes not only common stocks, but also other financial investments. The basic concept is for common stocks to be kept close to a certain constant ratio percentage of the total dollar value of the investor’s portfolio. Thus, if the stocks rise above that percentage by a predetermined percentage, some of the stocks would be sold to rebalance the total portfolio. The opposite would be true if the stocks decline below the constant ratio percentage.

The following example illustrates how the constant ratio works:

Original Investment Constant

Ratio

Current

Amount

Current

Percent

Constant Ratio Amount
Stocks $6,000 60% $8,150 67.9% $7,200
Bonds $3,500 35% $3,300 27.5% $4,200
Cash $   500 5% $500 4.6% $600
Total $10,000 100% $12,000 100.0% $12,000

Therefore, sufficient shares would need to be sold to bring the dollar amount of stock down to approximately $7,200 (i.e., the constant ratio amount), and the proceeds would be used to increase the bonds and cash close to the amounts indicated by their respective constant ratio.

Although the ratio is regarded as constant, it may actually need to be revised as the investor’s circumstances change (e.g., as the investor gets closer to retirement, he may want to invest more conservatively and, thus, reduce the percentage of common stocks).

In any case, it is best not to rebalance too often. If many stocks have to be bought or sold during the year to rebalance the total portfolio, more brokerage costs will be incurred. And, if a large number of stocks need to be sold from a taxable account, there may be a lot of gains and losses that will need to be reported.

c. Variable ratio: Like the constant ratio, this method is used to manage a portfolio that includes not only common stocks, but also other financial investments. Under this method, the percentage invested in common stocks is reduced when the prices of the stocks that are owned — or of the stock market in general — are believed to be high (i.e., overvalued). Conversely, when stock prices are thought to be low (i.e., undervalued), the percentage invested in common stocks is increased.

In addition to having the same problems as the constant ratio, the variable ratio raises the problem of how to determine, on a timely basis, when stock prices should be regarded as high or low, since they can go to extremes in either direction for months or even years, as was evidenced during the 1970s, 1980s, and 1990s.

3. Technical analysis: The focus of this method is on recurring patterns of stock price movement or recurring inter-relationships between stock price movements and other market data. Technical analysis may seem to be the equivalent of astrology or reading tea leaves, but there is logic as to why such analysis can provide useful information for investors. In any case, skillful use of technical analysis is difficult.

4. Stop orders: This method can be used for both purchases and sales of common stocks, although it is most often used for the latter. The buyer (or seller) sets a price that will automatically trigger the purchase (or sale) of a stock. Deciding on an appropriate stop-order price can be difficult. (Many investors use technical analysis to help them determine the stop-order price.) Once the stock reaches that price, it usually is bought (or sold) at the price of the next trade, with one or two exceptions. If the stock market is rising or declining rapidly at the time the stop order is triggered, the actual purchase (or sale) price may be significantly higher (or lower) than the stop order price.