An investor's decision to sell stocks is largely influenced by a flurry of emotions, wherein the current price of the stock and the cost of the stock act as major anchors. Investors often sell a good stock prematurely, hold on to a bad stock for too long, ride a momentum play only to see it backfire, and sell a stock at a loss in fear that it may fall further.
In reality, neither the stock price nor its cost should play a role in the selling decision. Ultimately, the strength of the business and its current valuations matter. An investor can control his emotions only when he has the desired patience, the ability to make rational decisions and belief in the company he is holding.
Although there is no definite rule about when to sell a stock, being rational is the first step. Once you have the required clarity of thinking, the following points may help:
Deteriorating fundamentals: If a company's profitability or profit margin or return on equity is declining consistently, it may indicate that the company is heading towards tough times. In such a case, investors can think of exiting the stock.
Valuations: If a stock is trading at very high valuations as compared to its historical valuations, that's a sign of caution. While such a stock may not fall just because its valuations are expensive, any decline in its earnings momentum can cause it to significantly correct.
Out-of-favour product: If the company's product (or service) is gradually moving out of favour owing to technological advancement or a changing regulatory environment, that's an indication to sell. For instance, the move towards hybrid or electric cars will gradually lead to a decline in the diesel- and petrol-car market and related auto ancillaries may have to face the brunt of this.
Debt: Increasing dependence on debt or excessive debt is a potential threat. In a slowdown, debt may eat away all the profits of the company and land it in trouble. Companies with debt to equity of more than one or nearly one should be closely monitored.
Management: Companies where there is doubt about management integrity should be avoided. An investor should sell the stock unless there is a very strong reason to stay invested in the company. Recent cases like Vakrangee, PC Jewellers, Manpasand Beverages, Yes Bank and 8K Miles have proved the importance of corporate governance. Further, a significant increase in pledging without any justified reason is another reason to sell a stock.
Auditor's report: If an auditor reports a lack of disclosure or incomplete information from the company, that's also a sign of caution.