INVESTMENTS

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The Independent Online
There is one thing that the investment world is never short of, and that is share tips. Most inexperienced investors think that finding the right things to buy is the sole object of the exercise. It is natural enough. For that is where the excitement in investing on the stock market lies. Of course, for those who want to speculate on shares that they hope will fall in future, it is possible to do so with traded options, but even then you have to buy something - a "put" option - to get into the game in the first place.

Far less attention is given to the queston of when to sell shares. Yet this can be just as important as finding when to buy them. Everyone who still owns Hanson or BTR shares, for example, must have bought them at some stage with high hopes of what they might do. But after several years of sparkling performance, they are both now languishing unloved, their share prices having gone sideways for years.

True, both companies still pay a handsome dividend, with yields after inflation that comfortably beat the obvious alternatives and provide useful compensation for the lack of recent capital appreciation. Hanson's demerger may yet provide the boost to the share price that was intended when Lord Hanson decided to dismantle the empire that he and Gordon White had so successfully constructed over 25 years.

Stock market history is full of those who declined to sell at the right moment, and lost all - or nearly all - of the money they thought they were going to make from a share which soared, only to crash to earth later. From Poseidon onwards, there have been plenty of mug investors who, like the Duke of York, rode their favourite shares right to the top of a bull market - and then all the way down again, sometimes ending up with nothing at all.

So, for those looking for above-average returns over time, knowing when to sell can be just as crucial as knowing what and when to buy. One method that is popular is a so-called "stop loss" system. This lays down that if your chosen share falls by a certain percentage below your purchase price, you should sell it regardless. That way you will ensure that you at least cut your losses on an investment that does not turn out well.

The technique is one that is borrowed from the gambling world, and is widely adopted in the trading fraternity. It is not inappropriate for those who regard investing in shares as something akin to gambling, or who take a lot of positions in the hope of short-term gains, as traders do. This method is essentially a discipline to stop you making a fool of yourself by dabbling in something where the risks are too high to be quantifiable.

Yet for those who regard investment in shares as a long-term process of wealth accumulation, and who believe that risks can be successfully managed by careful stock selection, the stop loss technique leaves a good deal to be desired. For the fact that a share has gone down does not in itself mean that the decision to buy was a mistake.

It does mean, obviously, that with hindsight your timing could have been been better, but perfect timing in the stock market is impossible to achieve. All that such an experience really shows is that, for the moment, there are others in the market who have missed the reason to buy that you have seen. Sentiment is against you.

Far from being a reason to sell, that may well reinforce the decision to buy. In the words of the investment writer John Train, "to sell a stock you understand just because it has gone down is an act of utter irrationality. If you are going sell every time the stock goes down, you will never win, any more than a general who always retreats when the enemy advances".

The key assumption in this kind of analysis is that you do understand the share you have bought and that nothing has happened to change the reasons why you bought it. As obtaining outperformance with shares is impossible without some degree of contrarianism, it is only logical that now and then shares you buy will actually fall before they start to appreciate again.

The more important question for long-term investors is whether a company's underlying business retains its economic advantages. If it does, and you bought the shares for reasons that still appear sound, then the last thing you should worry about is the short-term movements in the share price. Falls in the share price may well become an excuse for buying more, not selling.

Philip Fisher, one of the best and most original thinkers in the investment business, took this principle to its logical conclusion when he propounded the aphorism that "the best time to sell a share is - almost never". His own habit as a professional investment adviser has been to buy and hold favourite shares, such as Motorola and Intel, for literally decades at a time regardless of the overall state of the market.

His argument is that it makes no sense to sell shares you really like simply because you are worried that the market as a whole is going to decline. The rationale, set out in one of his masterly essays on the stock market, is that the overall direction of the market is impossible to call accurately. Quality, he argued, will always out in the end.

So where does that leave today's investors? Stick to those few companies you do understand and allow the market to take care of itself. Only if you have made a mistake in your original thinking does it make sense to sell just because the market falls. Of course, if you make a whole series of mistakes, then perhaps you are not quite as smart as you thought and it is time to put that stop loss system in place after all.

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