“Yes, but how do we make money doing that?”
From time to time, my wife engineers a trip to the local garden center so she can interrogate me about something. She’s clever that way. She knows that wandering around the house and garden puts me in an expansive mood.
The subject this weekend was our retirement account. My wife’s an outstanding prekindergarten educator. But finance and investment aren’t her strong suits.
“When money goes into our retirement account, I use it to buy shares in companies that I think will increase in value,” I explained. “If I’m right, then the value of our retirement account grows.”
She replied: “But you keep saying that the assets in our retirement account aren’t money. They’re shares in companies. So, how are we accumulating money for our retirement? We can’t eat companies.”
In her own unique way, my wife hit on a question I often get from my readers.
How, indeed, do we make money through investment? In other words, how do we know when it’s time to sell … to convert stocks back into cash?
When to Take Profits
Sometimes, the decision to sell stocks is made for us, like the required minimum distributions retirees must take from their IRAs or 401(k)s every year.
That’s an easy call to make — backed up by a hefty IRS penalty if you don’t.
But what about the assets left in that account, especially stocks? When should you sell those?
Well, when a company is declining in value with little hope of rebound, it certainly makes sense to sell. In that case, we’re preserving capital.
But the other situation — locking in profits on a winning position — is more complicated.
Profit-taking involves selling a winning position to convert those gains back into cash.
For example, if I buy $1,000 worth of shares in XYZ Corporation, and the stock appreciates by 50%, I now have an asset worth $1,500.
If I sell $500 worth of that stock, I’ve converted my gains into a cash profit. I still have $1,000 worth of XYZ shares, just fewer of them.
Here are the scenarios when I would recommend doing that:
- When it’s time to rebalance your portfolio. When one or more of your positions enjoys rapid gains, you’re quickly going to depart from your target allocation, whatever it may be. So, you’ll want to reduce your holdings in a winning stock.
- When the stock has reached a plateau and is likely to “consolidate” within a narrow band for an extended period. I know that sounds technical. But it’s actually quite simple. Most stocks tend to appreciate in distinct phases. In the consolidation phase, the price bounces between an upper resistance level and a lower support level. If the stock has a history of remaining in the consolidation phase for many months, taking profits may be a good idea.
Example of a consolidation pattern and breakout:
- To recycle profits into up-and-coming stocks. Instead of having your money dawdling through a consolidation period, it can be earning new gains on another position. You could take your $500 gain on XYZ Corporation and use it to invest in a hot new growth company that’s about to enjoy a breakout.
By contrast, if a stock is experiencing strong upward momentum, trading consistently above its 200-day moving average, I’d hang in there to grab the biggest gains possible. Wait for a confirmed move back toward the 200-day average price level and take profits then.
Good Advice Is Key
The ideal time to make a move on any stock — whether buying, selling or taking profits — is when the conditions are just right.
Consistently identifying those conditions correctly takes research and experience — and a lot of it. Identifying a likely bullish breakout, an extended consolidation phase or the right time to exit a position involves more than just reading the headlines.
That’s why Clint Lee and I spend most of our workday finding these price trends for you, so you don’t have to. In fact, we’ve just taken outstanding profits on one of our open positions!
And in case you’re wondering … yes, my wife is now a regular reader!
Editor, The Bauman Letter