How to decide when to sell

Selling stocks is one of the toughest areas of investing. Anyone who's been investing for a while can tell of a stock they sold after it had doubled ... only to watch it double or double again; or of a stock they cut after it had halved ... only to watch it recover and post handsome gains.

Supposedly to help – but really to justify the decisions they want to make – people throw around scores of sayings about when to sell. But if you followed most, or even a few, of them, you'd soon get yourself tied up in knots.

They say, for example, that 'you'll never go broke taking a profit', but they also say that 'selling your winners is like cutting the best flowers from your garden'. It seems you can't win.

So what should you do? The trick is to remember that success in the stockmarket comes from holding undervalued investments and that buying and selling are just a means to that end. So the idea is to maintain a diversified portfolio comprised of the most undervalued stocks you can find. On that basis, you'll buy a stock if:

(1) It is within your 'circle of competence' and you are therefore able to make confident assessments of (2) and (3); and

(2) The transaction makes your overall portfolio more undervalued; and

(3) It maintains an acceptable portfolio balance.

You'll notice that the second condition is relative. Its answer depends on your assessment of the value of your potential purchase and the value in your existing portfolio – or, more particularly, of the stock you'd sell to provide the funds to make the purchase, which might not be your least undervalued stock, depending on your answer to (3).

So buying and selling are really just two sides of the same coin. Flipping it over, you should sell a stock if:

(1) It is no longer within your circle of competence and you are not able to make confident assessments of (2) and (3); or

(2) The transaction makes your overall portfolio more undervalued; or

(3) It restores an acceptable portfolio balance.

Scrap heap

Note that we have now replaced the ands with ors. A stock needs to meet each of (1), (2) and (3) to find a place in your portfolio, but it only has to fail one of the conditions to find itself on the scrap heap.

But what happens if a stock is overvalued and needs to be sold and you can't find a suitable replacement? The answer is that you can replace it with cash. So the benchmark against which to measure a stock becomes cash, rather than another stock.

As the stockmarket becomes more expensive, and opportunities become thin on the ground, cash becomes an increasingly attractive option and your portfolio balance will be improved by holding some.

Rosy assumptions

Other people are less patient and the market has chased many income stocks up to prices that allow little or no margin of safety. Property trusts, for example, have seen their yields driven down towards 5% in some cases, with an implicit assumption that rent levels and near 100% occupancy rates can be maintained. In the retail and office sectors in particular, this could look optimistic in a few years' time. We still have a Buy recommendation on ALE Property Group – just – but we're steering clear of most of this sector.

ARB Corporation is another stock whose valuation seems to depend on a continuation of its recent strong performance, but this may be wishful thinking given the slowdown in the mining sector. We downgraded ARB to Sell on 21 May 13 (Sell – $13.49), before reverting to Hold when it fell back below $13, but the stock is nudging past that level again. We also sold the remaining shares in our Growth Portfolio on 21 May. We originally bought the shares for $3.05 in 2005, and have sold some previously – at $8.42 on 14 Apr 11, $9.315 on 4 Mar 12 and $12.52 on 4 Mar 13 – due to the holding becoming too large and therefore satisfying our third condition for selling, to restore an acceptable portfolio balance.

The banking sector may satisfy all three conditions. Not even the chief executive of these behemoths truly understands every risk they're taking – and don't be fooled by their omnipresence and the strength of their brands: these are risky businesses, as we explained in Time to sell the banks? on 30 May 13. You don't have to own banks to do well in the sharemarket. But if you do, we recommend that you look for a big margin of safety.

That appears to be lacking after the recent surge in their share prices, so we'd suggest that there is better value elsewhere, such as among the 19 stocks on our Buy list – or even, for the time being, in cash. We've suggested keeping your combined weighting in banks to below 20%, but due to current valuations and the potential second round impact of a slowing resources sector we'd consider a portfolio limit of 10% or less.

Shifting lanes

Overall, though, you should be careful not to try to do too much. The main problem most people encounter when putting all this theory into practice is overconfidence in their assessments of value, with the result that they make changes to their portfolio too frequently and leak much of their returns in trading costs. After all, with analysts and the media highly polarised on most stocks, it's never hard to find reasons for buying and selling (in contrast to this, the majority of our recommendations are boring, but realistic, Holds).

Most of us are wired up to prefer activity over inactivity and, if you traded a share every time the thought occurred, you'd rapidly hand over your portfolio to your broker. It's rather like shifting lanes in steady traffic – it feels as though you're doing some good, but you're probably just burning through more fuel. Generally speaking, you're best to get into a decent-looking lane and stay put.

Note: Our model Income Portfolio owns shares in ALE Property Group.