Source: Flickr user Snowlepard
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The stock market has taken investors on a wild ride over the last decade. From the end of the bull market to the trough of the Great Recession, all three major stock indexes lost in excess of 50%. But since then, all three indexes have doubled (or tripled), and, in the process of doing so, they've all taken out their prior all-time highs -- even the Nasdaq Composite,which took 15 years to do so.
After such an incredible run, the idea of selling some or all of one's stock has probably crossed the minds of more than a few investors. Locking in gains means you've done something right, but selling at the wrong time could wind up costing you a fortune in long-term gains.
Understanding when to sell stocks isn't easy, but the way I see it, there are five reasons why it might be OK to part ways with your stock.
1. Fundamental change in the business model
Determining when to sell a stock is simple if the thesis behind why you a bought a stock has changed. If you made a list of the variables that enticed you to buy a stock, and suddenly a number of those variables changed or are no longer in play, then selling the stock might make sense.
For example, the thesis behind owning discount flooring specialist Lumber Liquidators a few months ago was that it offered a quality product at a reasonable price and consumers loved it. Its management team had also eliminated the middleman in China, creating a vertically integrated flooring specialist that could benefit from lower costs.
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Source: Lumber Liquidators via Facebook
However, a report from 60 Minutes earlier this year alleged that Lumber Liquidators' Chinese-based laminate flooring contains unsafe levels of formaldehyde (a known carcinogen). This changed everything. Since then, we've witnessed the potential for criminal prosecution from U.S. lawmakers, and the resignation of its CEO. Together, this news throws the initial investment thesis out the window.
If there's a fundamental change in the business model or your initial reasoning behind buying a stock, then selling your stock might be a smart move.
2. Loss of faith in management or managerial change
Although Warren Buffett takes the approach of buying great businesses that could be run regardless of who's managing it, it's comforting as an investor to have faith in the management team leading a company whose shares you own. If there's a change in a company's management team, or your faith has been shaken in that management team, I believe it's a perfectly sound time to consider selling stock.
Source: Flickr user Nicola Jones.
In early 2014, Galena Biopharma stock was on fire, with the company riding high on strong results from its phase 2 study of cancer immunotherapy product NeuVax, which is designed to prevent cancer recurrence in select breast cancer patients.
Unfortunately, allegations surfaced shortly thereafter that the company had hired a third-party promoter to "promote" Galena's stock. While this isn't illegal, it is illegal if the arrangement isn't properly disclosed. A few months later, the now-former CEO of Galena, Mark Ahn, stepped down. While no clear connection was ever made between the stock-promoting company and Galena's management, this event was enough to damage investors' faith in management and send shares plummeting.
3. Excessive valuation
A third reason you might consider selling stock is because you believe its valuation is no longer justified, or it no longer fits within your investment thesis and/or risk tolerance.
Tesla Model S. Source: Tesla Motors
But selling because of a perceived excessive valuation is tricky because the valuation of a stock could always head higher. To speak of a personal story, I'm currently betting against (known as short-selling) shares of electric vehicles maker Tesla Motors , which is slated to lose money on a GAAP basis until 2020 and is valued at 72 times next year's profit projections. Compared to other automakers this is blatantly expensive, and on a production basis Detroit's automakers can make in a week or less what Tesla produces in an entire year. Despite this, Tesla's stock continues to rally, and I keep losing money. If prior shareholders sold their shares because they shared my belief they, too, would have given up potential gains.
Yet, if you're a value investor at heart and a company you own is valued at a P/E that's noticeably higher than the broader market or its peers, it could be worth entertaining the idea of selling the stock. Just understand that this is probably the trickiest of the five valid reasons to sell a stock.
4. Tax reasons
Sometimes the decision of when to sell stocks is made easier because of taxes.
Source: Bankrate via Facebook
One of the advantages to holding stocks for the long term (at least one year) are significant tax breaks. Currently, long-term trades will be taxed at either 0%, 15%, or 20%, depending on your income bracket. Comparatively, short-term trades of 364 days or less are taxed as ordinary income, thus anywhere from 10% to as high as 39.6%!
But, one advantage of selling stock at a loss is that it can help offset your investment capital gains, or simply help reduce your modified adjusted gross income. Unfortunately, if you lose $100,000 in a year, the maximum capital loss you can take against your income is $3,000. However, you can carry the remainder of your capital loss forward every subsequent year until you do eventually offset it with capital gains.
5. An emergency arises
Finally, it may not be the best reason of when to sell stocks, but emergencies do arise and statistics show that a good chunk of Americans aren't prepared to handle a financial emergency.
Source: Bankrate via Facebook
According to a Bankrate's Financial Security Index from June 2014, 26% of respondents had absolutely no emergency savings (which is defined as cash, or cash equivalents such as money market accounts or CDs), while another 24% maintained enough in their account to handle three months or less in expenses. The recommendation is to keep six months or more in emergency funds handy, but fewer than one-in-four respondents were at that level per Bankrate's survey.
Therefore, should an emergency arise, the idea of selling stock to raise capital might be an appropriate idea for some individuals. It could mean losing out on potential long-term gains, but it may also avert a short-term financial cash crunch.
Understand that there's no magic formula that decides whether a stock should or shouldn't be sold, so the decision will ultimately be up to you. However, taking these five important reasons of when to sell stocks into account should help make your decision to sell or not to sell that much easier.
The article When to Sell Stocks: 5 Times It's OK to Part Ways With Your Shares originally appeared on Fool.com.
Sean Williamsis short shares of Tesla Motors, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of, and recommends Lumber Liquidators, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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