When is the right time to pull the plug on an investment?

When I said recently that it can be better for an investor to travel than to arrive, I was referring to the Japanese market’s surge to within a whisker of the peak level it reached back in 1989. But the Nikkei 225 is not the only investment begging the question of whether or when to sell. India hit a new all-time high this week. The US is within striking distance too after the interest-rate driven Santa rally at the end of last year.

Of all the questions facing an investor, when to sell is perhaps the hardest. Not least because, unlike with the decision to make an investment, selling it requires you to undo something in which you have already invested intellectual, emotional and financial capital. That is psychologically hard to do.

There are plenty of reasons to sell an investment. Some of them are good, some bad. It’s important to understand why you are deciding to pull the plug. 

One of the reasons people struggle to decide whether or not to sell is that they don’t know why they bought in the first place. It is impossible to judge whether your investment thesis has changed if you don’t know what it was at the outset. So, write it down. Keeping an investment diary can give you something tangible against which to measure your decision. It’s good to remind yourself why you got together all those years ago!

Changing circumstances are a good reason to change your mind. The danger here is that you’re not the first to notice that things are different. Markets are pretty good at pricing in change. But what they are less good at is assessing the scale or durability of that change. This is why selling after bad news can still make sense. Humankind cannot bear very much reality. It can take quite some time for the penny to drop, and a share that has fallen by 50pc can still lose another 100pc.

Another good reason to sell is because you made a mistake. We all do it. Indeed, a successful investor can be one who simply makes more good decisions than bad. If you run your profits and cut your losses, a hit rate of only 50pc might be good enough.

One underrated reason to sell is to reduce the risk of holding onto a winning trade. I once advised a friend who had made a fantastic investment to sell enough shares to reduce his purchase cost to zero. It’s much easier when it’s other people’s money. At the time he could have done this by selling as little as a third of his holding. Doing so would have ensured that the worst possible outcome would be just getting his money back. He didn’t and it wasn’t.

Most of the other good reasons for selling are personal. Your risk appetite may have changed, and you can no longer tolerate the potential downside of an investment. You might simply need the cash. That, after all, is the reason we invest in the first place. To be able to spend our money one day in the future. Eventually, that day arrives. Meanwhile, you might be lucky and find that one or two good investments have shifted your portfolio away from your desired weightings. Rebalancing is a good reason to sell. 

What about the bad reasons to sell? Again, there are many. The worst reason to sell is because you have made a profit. Ironically this is also the easiest circumstance in which to bail out. Securing a profit provides temporary validation. And if the investment fails to notice that you have sold it and continues to rise, it’s easy to look the other way. Having a target price sounds sensible but it rarely makes sense to exit a winning trade. The trend is usually your friend.

Almost as bad is to sell because you have made a loss. At times, it can make sense to draw a line under a failed trade, but never simply because the price has gone down. This tells you nothing except what other investors are doing and how deeply ingrained is your loss aversion. It says nothing about the investment itself or whether you should stay or go.

The only thing worse than acting on the basis of what other investors are doing is responding to what they are saying. By definition, the commentary and newsflow around a share that has fallen will be negative. Being a contrarian is a hard trick to pull off consistently, but it is essential. Going against the herd stimulates the same part of the brain as physical pain. It really hurts to be outside the group. But it is madness to do what everyone else is and to expect a different outcome.

One final, really bad reason to sell is because you are scared. If the news headlines are so grim that you want to hide in a corner until things look better, you can be sure every other investor feels the same way. That can be a recipe for abandoning an oversold investment that’s ripe for a rebound. The only worse emotion than fear as a trigger for selling is boredom. Very often we just feel we need to do something. Invariably we shouldn’t.

Given the propensity for markets to go up over time, the safest default is to do nothing. Time is a great healer. But there are times when the odds are stacked against you making an acceptable return in a reasonable timescale. Signs that the risks outweigh the potential rewards include significantly higher valuations than the long-term averages, very narrow market leadership and a widely shared consensus. Nothing should get your antennae twitching more than everyone agreeing about something.

Tom Stevenson is an investment director at Fidelity International. The views are his own.