When to sell your stocks: 5 thumb rules!

Knowing when to sell a stock is probably the trickiest question you will face as an investor. Usually, broker reports will tell you when to buy a stock, but until there are some compelling reasons to sell, there will hardly be a follow-up on it.

The dilemma surfaces when the price of the stock sees a huge run-up over a short span of time, as has happened in the Indian stockmarkets in the last one year.

You are left unsure and unguided whether to book profits or hold on to the stock in anticipation of even greater gains.

We've been receiving queries from readers about when to sell a stock. Here, we elaborate on five time-tested thumb rules. However, it must be noted that these rules should be treated as a guide, not a strategy, because judgment will always play a crucial role.

Rule 1: Fundamental value

Every stock has a fundamental value, obtained by discounting the company's expected future earnings. To arrive at this value, you can do your own calculations, or get in touch with a reputed broker.

As a general rule, you should buy a stock below its fundamental value and sell it when its price reaches or exceeds the fundamental value. The difference between the two prices is the gain that you make.

Sounds simple, doesn't it? However, confusion could arise when you find that the stock's price has gone past its fundamental value in a very short period and the market continues to be bullish on its performance. In such a case, should you continue to hold on to the stock?

Says Ashu Madan, president, equity broking, Religare Securities: "You should get out of the stock as a matter of discipline. That is when you have to control your greed."

However, there is an exception to this rule. Some external or company-specific factors can alter a company's business prospects. In this case, you have to reassess the stock's fundamental value and the company's prospects, and act accordingly. Click NEXT to check out the other rules. . .

Rule 2: History is your guide

Although knowing the fundamental value of a stock is core to a sell-decision, the process of calculating it can be extremely complicated. You can use an alternative way for finding the opportune time to sell a stock.

Says Gaurav Dua, research head at Mumbai-based brokerage Sharekhan: "Conservative investors can look at the average valuation [such as the price-to-earnings (PE) multiple] over the last 4-5 years."

Dua explains that the stock's earnings multiple, historically, trades in a range. Whenever it is below the low end of the range, it is a buy signal. On the other hand, if it moves over the range's high end, it indicates a sell.

Take, for instance, commercial vehicle manufacturer Ashok Leyland. In the last five years, most of the times (around 70 per cent) its PE has remained in the range of 10-20. It has traded above a PE multiple of 20 on only 15 per cent of the times. Thus, its current PE of 54 definitely signals a sell. Click NEXT to check out the other rules. . .

Rule 3: Earnings yield

There is another easy way to decide when to sell a stock. Says P Phani Shekhar, fund manager at Angel Broking: "Look at the company's earnings yield. If it is less than the post-tax risk-free rate, there is no incentive in holding the stock."

Let's elaborate on it further. Earnings yield is the reciprocal of PE multiple. PE multiple means the price you pay for each rupee of the company's earnings. So, its reciprocal, earnings yield, would mean the amount that the company returns (earns) on each rupee that you paid to buy its share.

Now, this is analogous to the return that you get on a bond. So, you can compare a stock's earnings yield to the return on bond (after adjusting the tax on bond earnings).

Since stocks are riskier than bonds, it should have a better yield. If it is less, it is advisable to sell the stock. On the contrary, a stock is attractive if the earnings yield is higher than post-tax bond yield.

For example, consider shares of the courier company Blue Dart. In September 2008, its earnings yield stood at around 8.5 per cent and the stock looked attractively priced. Now, the stock's earnings yield has declined to 3.25 per cent and, at the same time, the 10-year government bond yield stands at 7.61 per cent.

Adjust it for a marginal tax rate of 30 per cent and the post-tax bond yield will be 5.33 per cent. So, a smaller earnings yield on the Blue Dart stock compared to the post-tax bond yield makes it unattractive. Click NEXT to check out the other rules. . .

Rule 4: Rebalance your portfolio

The need to maintain a well-diversified portfolio is another relevant reason to sell a stock. The value of a company's shares in your portfolio could double or triple in a short span.

In such a case, the weight of the portfolio would tilt towards one stock, making the overall portfolio riskier than before. You can sell some portion of that stock to rebalance the portfolio.

Consider an example. Suppose your stocks portfolio is worth Rs 100, and you have a share of company ABC worth Rs 10. Currently, the weight of ABC in the overall portfolio is 10 per cent (10/100).

Let's assume the value of ABC's stock jumps to Rs 20 while the value of other shares in the portfolio remains the same. Now, ABC's weight in the portfolio has increased to around 18 per cent (20/110).

This means your portfolio is overweight on one company. To rebalance the portfolio, you can sell some shares of ABC. Click NEXT to check out the fifth rule. . .

Rule 5: Behavioural issues

Sometimes, shares of a company fall due to strong reasons. People who have invested in such shares should sell the stock immediately to minimise losses. However, some investors start accumulating it further, and they call it dollar cost averaging (buying regularly to reduce the average cost).

However, the truth is that these investors are not willing to accept the fact that they made a wrong decision of buying that stock. The result is they end up holding a laggard stock.

Some extraordinary events should also trigger a sell. An example is Satyam Computer Services. The company's future was uncertain when the scandal broke out.

Although in hindsight one can say that investors would have profited had they bought the stock when it crashed, the best decision at that moment was to exit.

Another behavioural bias often noticed is the inclination for not paying short-term capital gains tax. Even when a stock gets overvalued in a short period, some investors continue to hold on to it to avoid tax on capital gains. However, they ignore the fact that they are risking their capital.

"Calculate how much tax you have to pay. After that if the amount satisfies you, book profit," suggests Shekhar.

Ashu Madan gives another reason to sell. Citing the Reliance Power IPO, he says: "Whenever you see unrealistic exuberance or euphoria in the market, you should get out of the market. Although you cannot time when it will fall, but that is the scenario when you should exit."

These are some of the rules that will help you make the right judgment. However, one single rule may not apply to all stocks in all the cases. The decision, therefore, should be taken in entirety.