2 AAII Journal/September 1999

STOCK STRATEGIES

For many investors,selling is theirgreatest investmentweakness. Rememberthat if your profitsoutweigh your losses,you are makingprogress. Spend timelearning from yourmistakes, andconsistently use sellrules that keep theemotion and ego outof investing.

SELL RULES TO BUILD YOURSTOCK INVESTING PERFORMANCE

Even the most successful investors make mistakes. The key to investing isrecognizing early on when you’ve made a questionable investment decision.

Well-known investor Bernard Baruch said, “Even being right three or fourtimes out of 10 should yield a person a fortune if they have the sense to cutlosses quickly.”

When you make a mistake, admit it and move on—it is a simple rule, butone few investors are willing to follow consistently. If emotions and egointerfere with rule-based investing, these traits can become an investor’s worstenemy and are the most difficult habits to erase. If you want to be a success-ful individual investor, you need to be as unemotional as possible in yourresponse to the stock market. The biggest challenge is to acquire disciplineand make your decisions fact-based.

Here are some proven sell guidelines I’ve used over the years very success-fully. These sell rules are broken down into categories. Their combinedstrengths will become apparent to those who apply them consistently.

SELLING TO CUT LOSSES

The most critical rule every investor should follow is to cut losses. This is byfar the soundest, most logical way to protect your portfolio against seriouslosses.

All stocks are speculative and involve risk. If a stock goes 7% or 8% belowyour purchase price, sell it. Sometimes after you sell to cut a loss, the stockwill go back up in price. Were you really wrong if you sold your stock and itwent back up? Were you also wrong for buying fire and car insurance whenneither your house burned down nor you got into an accident? Think of the7% to 8% sell rule as your small insurance policy against potentially devas-tating losses from which you can’t easily recover.

If you have a worthwhile gain in a stock, you might ask if you should sellwhen the stock drops 7% from its peak. The 7% cutting losses rule does notapply in this situation. Once you have a profit in the stock, other rules comeinto play (discussed below under ‘Selling to Take a Profit’).

My philosophy is, “There are no good stocks … they’re all bad … unlessthey go up in price.” Make your losses smaller by recognizing this early on.Stocks should remain in your portfolio only as long as they perform well foryou.

What about the “averaging down” strategy of buying more shares in astock if the price drops? My advice is, don’t do it—it is throwing good moneyafter bad. The only averaging that makes sense is “averaging up” in yourpurchasing. Here’s why: The most important factor in selling is buying atexactly the right time—not too early and not too late. Wait for the right timeto buy, when a stock comes out of a sound chart base or price-consolidationperiod. If you begin buying at the correct buy point, the stock will rarely go

By William J. O’Neil

William J. O’Neil is chairman and founder of Investor’s Business Daily, a nationalbusiness and financial newspaper. He is also the author of “24 Lessons to InvestmentSuccess,” published by McGraw-Hill and due in stores at the end of October. To receivetwo weeks free of Investor’s Business Daily and the free 45-minute video “MaximizingYour Success,” call 800-290-9394; there is no obligation.

AAII Journal/September 1999 3

STOCK STRATEGIES

7% or 8% below your purchaseprice. If you buy later when a stockis 10%, 20%, or 30% extendedfrom a sound chart base, you will beshaken out on minor 8% pullbacksin price much more frequently.

SELL INDICATORS

Beyond the loss-cutting rule,watching a number of key funda-mental variables in a stock will beyour best ally. In general, thosevariables concern earnings, priceaction, industry or group action,profitability, and volume. This isreally the “flip side” of buying, sincethese are the same variables youwould examine when making apurchase decision.

You should consider selling anystock you hold that starts to showweakness in the following areas; youcan find information that will helpyou track these variables inInvestor’s Business Daily’s (IBD)SmartSelect™ Corporate Ratings,which compare each stock relativeto all other stocks:••••• Earnings per Share: A stock’s

earnings growth is the mostimportant characteristic influenc-ing a stock’s price. Ideally, youshould seek stocks showingcurrent earnings increases of atleast 20% over the same quarter’searnings one year prior and withpast earnings of at least 25%annually for the last five years.Consider selling if a stock’searnings performance starts tofalter, or if the earnings growthdrops to only average relative toall other stocks (an IBDSmartSelect™ EPS rating of 70 orbelow, based on a relative scale of1 to 99, with 99 the highestrating).

••••• Relative Price Strength (pricemovement relative to otherstocks): A stock’s price should beoutperforming (moving up fasterthan) 80% or more of otherstocks. Consider selling if therelative strength starts to trenddown, or has an IBD

SmartSelect™ RS rating of lowerthan 70 (based on a relative scaleof 1 to 99, with 99 the highestrelative strength).

••••• Industry Relative Strength: Stocksalso do well when they are in aleading or strong industry group.Avoid stocks in lagging industries(an IBD SmartSelect™ IndustryGroup Relative Strength rating of‘D’ or ‘E,’ based on a scale of ‘A’to ‘E’ with ‘A’ indicating the top20%).

••••• Profitability: A company shouldshow strong market potential forits products and services, as wellas the ability to turn sales intoprofits. Look for strong andaccelerating quarterly salesgrowth, high profit margins (netincome divided by revenue) of18% or more, and high returns onequity (net income after allexpenses and taxes divided bystockholder’s equity) of 17% orhigher. You should considerselling if these measures fall belowaverage (an IBD SmartSelect™SMR—sales, margins, and ROE—rating below ‘B,’ based on a scaleof ‘A’ to ‘E’).

••••• Accumulation/Distribution:Ideally, a stock should be experi-encing moderate to heavy accumu-lation by the institutions. Considerselling if a stock has experiencedmoderate to heavy selling (calleddistribution) in the latest three-month period (an IBDSmartSelect™ Accumulation/Distribution rating of ‘D’ or ‘E’).

SELLING TO TAKE PROFITS

As you make better stock selec-tions, your challenge will be todetermine the best time to sell andtake your profits. This one decisionhas paralyzed more investors thanalmost any other. It is not enough tobe a good stockpicker. To maximizeyour profits, timing your sells whenthe stock has gone up is as impor-tant as your buys.

The best time to sell and take yourprofit is when your stock is advanc-

ing and still looks strong andpositive to most investors. If you’reable to time this type of sale cor-rectly, you won’t get caught in adrop or correction.

Here are some specific examples ofwhen you may want to considerselling:• The second time a stock splits in

less than 12 months.• A stock breaks up out of a base or

runs up in price, yet the relativestrength line does not break outinto new highs, but lags substan-tially.

• There is a huge volume increase asa stock breaks below its 10-weekmoving average line.

• After months of significant priceadvance, a stock runs up fasterthan normal in just one or twoweeks (usually 25% to 50%).

• Last two quarterly earningsreports show significant decelera-tion in their percent rate ofincrease.

• The majority of market leaders inthe industry group have topped.

• The stock breaks up out of a base,but does so on less volume thanthe week before, or daily volumedoes not increase at least 40% or50% on the first day or two of abreakout.

• After a long run-up for severalmonths, the stock opens up on aprice gap from the day before.

• The general market averages haveclearly topped and several of themarket leaders showed climax topaction.

• Heavy volume increases arerepeatedly shown as the stockdrops.

• The fourth time a stock builds abase on the way up and breaksout to the upside (usually theprice pattern will appear morewide and loose).

• Sell when you are all excitedabout all the money you’remaking and everyone is talkingabout what a great stock it is.

• Weed the flower patch—sell yourweakest stocks first.If several of these factors apply,

4 AAII Journal/September 1999

STOCK STRATEGIES

the case for selling becomes evenmore compelling. Figure 1 is anexample of a stock that displayedseveral of these characteristics inlate June.

THE MARKET

You can be right on your stockselections, but if you’re wrong aboutthe direction of the broad generalmarket, you could have problems.Three out of four of your stocks willusually slump with the marketaverages, and you will lose money.

The key is to learn to read andinterpret the general market indexes:Determine whether you are in aclear uptrend or downtrend in theoverall market. And are you in theearly or later stages? Is the marketweak or acting poorly, or is it justmoving through a normal decline?

Look for confirmation or divergencein the three major indexes for clues.

Market tops: I firmly believe thatif you read the general marketcharts each day, you will, in time,learn to spot when the market istopping.

A market top always happens onthe way up. You will encounterthree, four or five days over aperiod of a few weeks where volumewill increase from the day before,and the index price (Dow Jones,Nasdaq, or S&P) will either clearlyclose down from the prior day orstall and make very poor progress.These are “distribution” days, andafter four or five days of thischurning on increased volume withpoor price progress, the market willusually turn down.

When you spot a definite top inthe market, it is usually prudent to

sell at least a few positions. Youdon’t need to go to 100% cash, butlightening up your positions andgetting off margin (if you useborrowed money) can be a sounddecision in this instance. In otherwords, stop buying and reduce somepositions to protect yourself frompossible problems that might develop.

Attempted Rallies and MarketBottoms: At some point, the marketaverages will attempt to turnupward and rally. Don’t get drawninto the first or second day of anyattempted rallies—they could befalse. Don’t resume your buyinguntil the market signals a clear andpowerful follow-through. Thisusually occurs between the fourthand seventh day of most attemptedrallies. A follow-through will havethe market up for the day more than1% and on higher volume than the

FIGURE 1. AN EXAMPLE OF SELL CHARACTERISTICS WHEN TAKING PROFITS

2/1 Stock splits occur many times near the top

WeakRally

Climax Run 29% in 2 weeks

Long term price trendline and 50day moving average line isbroken on heavy volume

Exhaustion Gap

Insider Selling

Low volume during attempted rally

AAII Journal/September 1999 5

STOCK STRATEGIES

••••• Remember, no one is 100% right all the time. Ifyour profits outweigh your losses, you aremaking progress. Spend time learning fromyour mistakes, and consistently use sell rulesthat keep the emotion and ego out of investing.

••••• Buying “right” will solve half of the sellingquestions. First, buy “right” on well-groundedfundamentals. Second, if you buy at the righttime (pivot point) where a stock is showing theappropriate base structure, your stock willseldom drop 8% below purchase price. If youbuy more than 5% to 10% past the pivot point,the price is extended … and you are probablytoo late.

••••• Always cut losses at 7%–8%.

••••• If you do not take a worthwhile profit when you

SELLING RULES: A SUMMARY

have it, do not let a stock fall back below yourpurchase price. One should sell and avoid theloss.

••••• Do not let yourself get shaken out of a stock thathas recently broken out and pulled back. The firsttime a stock pulls back to its 10-week movingaverage, it might be a buying opportunity.

••••• An initial 20% gain in only 1, 2, or 3 weeks shouldwarrant holding a stock for a longer period oftime since this may be an indication of real powerand leadership.

••••• Big price advances take time, so be patient aftera quality stock market leader has advanced. Youmay have to sit through the stock’s first normalcorrection of 20% if you expect to capture asignificant profit.

day before.

FINAL TIPS

Don’t ever follow tips—other thanthis one—or rumors. Rely on provenrules and facts. Being disciplinedenough to take advantage of the nextmarket move is the real challenge.

In addition, it is essential that youreview all your investment decisions

to see where you went right orwrong. I can’t emphasize enoughhow helpful post analyses of yoursells—both the profitable ones andthe losses—will be to improvingyour decision-making ability. Mypost analyses of my own failures inpoor selling was the key turningpoint in learning to succeed in thestock market. You’ll gain a strongerunderstanding of what you need to

change if you plot on charts whereyou bought and sold all your stocks.

Knute Rockne once stated, “Theway to succeed is to build up yourweaknesses until they become yourstrengths.”

I believe that for many people,selling is their greatest investingweakness. Once selling is mastered,you should be on the road tosuccess. ✦✦✦✦✦