Almost any book on investing will have chapters, explanations, equations and analysis – pages of them – explaining how you should pick stocks for investing. In other words, it is all about what you should buy for your portfolio. It is the same with videos or courses on investing, or for that matter, with most of the airtime on business channels.

Very little is written or understood about when to sell a stock

Even when something is written about selling a stock, it is usually asking you to look for turns in the business cycle or in the company financials or valuations. Many of these involve bets about the future, which may be completely incorrect as you do not know how the company’s future may pan out.

Selling, it is implied, is even more of an art than buying. Of course, there will be some experts recommending a blind “buy and hold” or “buy and forget” strategy, usually with cherry-picked examples. Meaning they will only pick the success stories which demonstrate that holding something for ten years or twenty years has worked very well.

They will not discuss what happened to all the other companies or stocks that an investor would have bought at the same time as these successful stocks, but which went nowhere. They will not point out that many successful stocks of the present went through long periods of no returns at all. Apple, for example, was a very poor performer for a good twenty years following its listing. This is something I have discussed in another chapter.

The best thing you can do for your portfolio returns

Coming back to the question we started with: when should you sell a stock that you hold?

As I have written in the chapter on following famous investors, Warren Buffett sells nearly 80 per cent of his positions within two years. This means he recognises that 80 per cent of his bets are wrong. Many talk about his buy-and-hold philosophy, but the data is completely to the contrary.

The best thing you can do when investing in security is to tell yourself that you may be making a mistake, as a certain proportion of your decisions will certainly not have the outcomes you had expected or desired.

This may happen even when the decision process has been correct, but the very fact that you are making a decision about the future, and that the future is unknown, means a certain number of times things will not go as you expected them to.

Why you shouldn’t have a price target…

So, when do you sell?

Let’s start with what not to do. Which is, don’t decide at the time you buy a stock that you are going to sell it if it goes up to X.

If you’re buying a stock at Rs 60, don’t decide that you will sell it when it quotes at Rs 100 or Rs 150 or Rs 200, because that way you will miss out on the multibaggers.

When you are buying a portfolio of twenty, twenty-five or thirty stocks, you don’t know which of them are going to be multibaggers – which are those that will go up several times. You do hope and expect that maybe one, maybe two, maybe three of them might be multibaggers.

But you do not know in advance which of the stocks are going to be in that category. So let your profits run.

As an aside, what most investors do is the opposite of this strategy – meaning, they let their losses run, at times waiting for their cost price to come back, whereas they book profits on their winners.

This is the exact opposite of what you should be doing, as I have said. The reason we don’t do that is because very painful for human beings to book losses. It is called loss-aversion bias and is the cause of losses and underperformance in many portfolios.

…But always have a stop loss

What you must have when you buy stocks is a stop-loss level. Decide what the stop-loss will be – say, 25 per cent or 30 per cent.

For our First Global portfolios, we use a complex algorithm to decide on the stop-loss levels, depending on factors like the volatility of each stock, or how much it goes up and down normally But even a simple stop-loss level will work. The important thing is to decide on it upfront and stick to it.

The stop loss has to be a trailing stop loss. That means it is not from your purchase price. If you buy something at Rs 60 and have a stop loss of 25 per cent, it does not mean that your stop loss is at 75 per cent of Rs 60, i.e. Rs 45.

What does trailing stop loss mean? First, it means that the stop-loss price keeps changing as the market price of the stock keeps changing.

If a stock goes up from Rs 60 to Rs 200 and you have a 25 per cent stop loss, then you will sell if it falls to Rs 150. You won’t wait till it falls to Rs 45, which is 25 per cent down from your buying price.

So if your stock falls from Rs 200 to Rs 150, you sell.

Does this mean that if you sell at Rs 150, the stock will not go up again?

Of course not! There may be cases when the stock keeps falling and there may be cases when the stock goes up again. But overall, on average, this strategy will save you serious money.

Averaging down?

Some “experts” will advise that you average down in stocks that you have high conviction in when their prices fall.

This is an extremely dangerous strategy as your mind will always trick you into saying that your conviction was right and the market is currently wrong. That is almost never the truth.

At times, you might, at a later stage, even go back into that stock at a lower price, or even at a higher price, but that’s a separate decision altogether. And you should look at it as a fresh investment, without letting your history with the stock be a hangover on that decision.

Put in place a system…and don’t override it

The important part lies in following the discipline of keeping to this rule. For example, in our portfolio management, we say the decision is by human plus machine on the purchase side, but strictly by machine on the risk management side, including implementation of stop loss. Simply because human beings do not want to admit their mistakes.

Machines, on the other hand, have no problem admitting mistakes. When a stock you hold hits a stop loss, your instinct will be to say, “This time it is different”, “It doesn’t apply to this stock”, “Let’s wait a while”, “I have high conviction on this”. All these are justifications or rather excuses, the human mind is sure to make up. This approach will result in poor performance or underperformance for your portfolio over a period of time.

The other side of this is that you should let profits run— – meaning, do not sell a stock that is going up.

The exception to the rule

The exception to this rule is when a stock becomes an outsized part of your portfolio.

If a single stock becomes 40–50–70 per cent of your portfolio because it has gone up multiple times, then you might want to trim it and book some profits just so that you don’t have such an outsized exposure to a single stock.

The other exception would be in the case of small-cap stocks, where stop losses do not work well as when some of these stocks fall, they go down so fast that you are unable to exit.

There, to err on the side of caution, you may book part profits even when the stock is going up.

Excerpted with permission from Money, Myths and Mantras: The Ultimate Investment Guide, Devina Mehra, Penguin India.