The Rules for Getting Out Safely

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Investors rarely receive guidance on getting out of a stock at the right time. Brokers, investment literature and even knowledgeable friends and associates with "tips" on when to buy are usually mute about when to sell. However, the right selling discipline is essential in order to preserve gains and stem losses. Professional traders always have a selling plan at the same time that they take a position in a stock--and so should you.

Signs that you need a selling strategy

  • Your portfolio is cluttered with groups of securities bought for what appeared to be sound reasons (a "good story") some years ago but which are now well below your purchase price. typical: Energy or personal-computer stocks. You are now "holding them for the long term" or until you can "get even" by selling them for the same price at which you bought them.
  • You have a paper profit in a stock that is now trading at a price well above what you expected it to achieve, but you're still holding on. Questions: What is the top? And what is your plan for getting out promptly?

Capital conservation basics

  • Rule number one: The first time that a broker downgrades his recommendation of a stock that you've purchased, sell! Brokerage firms always rank stocks they have recommended, starting with the best (usually called highly recommended or some such term) through hold and even, finally, to sell. Keep in touch with your broker on the stock's standing. Explain that you want to be informed immediately if the firm's analysts move it down a peg. If the move is, say, to hold, that tells you the analyst now doesn't believe there is much upside potential. You may miss some profits selling at this stage, but in the long run you'll come out ahead.
  • Rule number two: If the earnings estimates on a stock you own drop by more than 10% from previous estimates, sell! The first cut in earnings projections for a company is rarely the last. Even if the analyst continues to be optimistic about the company's outlook and recommends it as a strong buy, you should stay on guard and prepare to sell quickly. Again, you'll miss a few winners by following this rule all the time. But you'll sleep better, and your portfolio will stay healthier over the long run.

Using stop-loss orders

  • Use the simple tool of professional traders to lock in profits or avoid dangerous price erosion: stop-loss orders. These are orders to the broker to sell the stock when it reaches a specific price. Place a stop-loss order with your broker to trigger a sale when the stock hits 10% below its current market price.
  • If you already have a gain of more than 10% on the stock, the stop-loss order will preserve some of the gain if the stock begins to slip. The order must be put in at a certain price--say, 54 on a stock now selling at 60. Then, if the stock continues its upward trend, keep moving your stop-loss order up on a point-for-point basis.

When you add a new stock to your portfolio

  • Simultaneously ask your broker to place a good-till-canceled stop-loss order on the stock at a price about 10% below your purchase price, or even 5% below, if you decide that is the limit of your tolerance for risk.
  • Set an upside objective for the stock, a price at which you consider the stock to be fully valued. Example: Let's say you buy the stock at nine times projected earnings, and you think it will be fully valued when it reaches 15 times earnings. Once the stock has reached your objective, place a stop-loss order at a price 5% below that full-value price. Then keep that order in at 5% below the market price if the stock keeps going up.

Excerpt from: Book of Inside Information based on John Connallon, then first vice president, research, Shearson Lehman Brothers.

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