See 19 July 2018 issue of Shares for part one of this feature: ‘The big decision: take profits or run your winners?’

Deciding when to pocket profits after an investment has done well is one thing but knowing when to cut your losses when things go wrong is an even more difficult dilemma.

Share prices and stock markets go up and down all day every day and the reasons for the movements are not always clear. When a share price falls, investors need to make a call: is this a temporary set back or is it time to sell?

Simon Gergel, manager of Merchants Trust (MRCH), comments: ‘This is something people don’t think about nearly enough, and you can lose a lot of money if you get it wrong.’

WHAT TO DO

The first step for investors is to determine whether the share price has fallen because it is simply out of favour or because there has been a major event of fundamental change.

Gergel says investors should remind themselves of the reasons they first bought the stock and work out whether these reasons still stand.

If the move is just market noise that’s probably not a reason to sell. However, if there has been a material change, the next step is to work out how that changes the outlook for the business and the ‘fair value’ for its shares.

Investors often have a ‘target price’ in mind for the shares of companies they invest in – the price they believe is a fair reflection of the value  of the business – but they should be constantly
re-evaluating what that figure is.

Joe Bauernfreund, manager of British Empire Trust (BTEM), says: ‘When a share price falls we have to work out whether it’s just got cheaper and we should be buying more or if we have made a mistake.’

THE LOSS AVERSION MISTAKE

A common mistake that investors make is to do with what psychologists call ‘loss aversion’: when the value of their investment has fallen they stick with it in the hope that it will recover.

Like a gambler in a casino hoping to win their money back, the belief is that they haven’t lost until they have crystallised the loss. But professionals say it’s vital to know when it’s time to admit defeat and cut your losses.

Gergel once bought shares in telecoms giant  BT (BT.A) and sold them less than a month  later – very unusual for a fund manager.

He says: ‘We had a specific reason for investing in the shares but there were accounting issues and a profit warning and the investment case didn’t work anymore. We took a 10% to 15% loss on the shares but had we held on it would have been much greater.’

But, he admits, he doesn’t always act so quickly: ‘We have had other situations that have gone on longer, where we should have realised sooner that it was time to sell.’ This can happen when there have been subtle changes in a company over time rather than a single overnight event that hits the shares.

Gergel advises: ‘Write down the reasons why you bought a share; that makes it easier to tell if they no longer apply.’

OTHER REASONS TO SELL

Changes to an industry can also spark a sell decision. Bauerfreund last year sold shares in Canadian company Hudson’s Bay, which owns department stores and retail real estate across America.

There wasn’t a single event which led to his decision so much as a gradually growing concern about the spiralling state of the sector. He says: ‘Retail is getting decimated, profitability is under pressure and it was a situation where the value had fallen and you had to cut your losses.’

There are also times when shares do recover. Gergel added to his investment in Tate & Lyle (TATE) earlier this year when he thought the market had overreacted to some short-term issues. After dropping more than 10% overnight the shares have since recovered.

Similarly, he stuck with oil giant Royal Dutch Shell (RDSB) two years ago when there was widespread concern it would cut its dividend. With a yield of 8%, Gergel thought even if the dividend was reduced it was still a good option for income; he’s made a 100% return on the shares over the past two years.

WEIGHING UP THE EVIDENCE

But how do you know when a share will bounce back and when it only has further to fall?

Gergel says: ‘Years of experience helps and so does working with colleagues who had different views and challenge you; hearing the other side of an argument is really important.’

Bauernfreund says having the inside track helps. Fund managers are able to meet with the management of the companies they invest in, which bestows them with a much greater insight into whether there are issues.

Having a team of researchers is also vital to him, particularly when investing in small and mid-cap companies, which are not as well covered by analysts as larger firms.

Bauernfreund says: ‘We try not to get spooked by what the market does – investors don’t always behave rationally – but sometimes the facts change.’ (HB)

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