Warren Buffett: When to Sell a Stock
The question I want to answer in this video is probably the single most difficult question in all of investing: When is the perfect time to sell a stock? Countless books have been written and videos have been made on when the right time to buy a stock is. However, it seems to me like much less focus has been given on the equally important topic of when to sell. To answer this question, I'm turning to someone who has both bought and sold his fair share of stock in his lifetime: Warren Buffett.
In this video, we are going to examine the three reasons Buffett has provided as to why an investor should sell a stock. Make sure to like this video, because a ton of effort went into the research process of this video, including combing through countless articles Buffett has written and interviews he has given. It really motivates me to keep making this content; you guys are great. Now, let's get into the video.
Most investors, whether they like to admit it or not, sell stocks for three main reasons. In this example, let's meet Joe. He is our average investor. Get it? Average Joe Investor? Okay, it was worth a shot.
Anyways, Joe acts like most investors, and he sells for one of the following reasons. The first reason Joe sells is because the stock has gone up in value. Joe remembers an old saying: Nobody ever went broke taking a profit. Now, we'll get into this more later on, but let's agree that this saying can be modified to also say: No one ever got rich selling a stock they just bought a few months ago, especially when you have to pay short-term capital gains in the United States on stocks you held for less than a year.
Most investors have been in the same predicament. They do all this research on a stock and make the decision to buy. The stock goes up 20%, so then they sell out of the position, only to watch the stock 2x, 3x, or even 10x.
The next reason why Joe sells the stock is because the stock is flatlined. He bought the stock a few months ago, and the price of the stock hasn't really moved much. The stock has hovered around the same price for a few months while Joe has seen his friends put their money into Bitcoin or high-risk speculative stocks and see big increases. Joe doesn't have much patience, so he sells out of his shares to buy a more speculative, risky stock at the top of the market, only to see that new stock fall in value by 10%, 20%, or even 30% right after Joe bought it.
And then the third reason Joe sells: He did a lot of research and identified a company that he thinks will make a good long-term investment. Shortly after Joe buys, the stock falls 20% over the next few months for seemingly no valid reason. Joe thinks to himself that other people must know something that he doesn't. He only sees Jim Cramer on TV talking about how the stock is a bad investment, so Joe sells the stock. He then watches the stock go up in value over the course of the next few years by 50%, eventually even doubling and tripling in value while Joe lost 20% of his investment selling too early.
The reason Joe here is selling at all the wrong times is because he isn't viewing the stock that he bought as an ownership stake in an underlying business. Instead, he is viewing the stock as just something that floats around in price for seemingly no reason. Listen to what Buffett has said on this topic: "Certainly most of the professional investors focus on what the stock is likely to do in the next year or two, and there are all kinds of arcane methods of approaching that, but they do not really think of themselves as owning a piece of a business."
So now that we understand why most people sell, let's get to why investors should actually sell, according to Warren Buffett. The first reason is when a better investment comes along.
"The first 20 years of investing for me, or maybe more, my decision to sell almost always was based on the fact that I found something else I was dying to buy. I mean, I sold stocks at, you know, at three times earnings to buy stocks at two times earnings 45 years ago. Because when I started out, I had way more ideas than money. I mean, I would go through Moody's Manual, I went through it page by page, and then I went through it again page by page. I found stocks in there that I could understand that were selling at like two times earnings, even one times earnings. Well, when you only have ten thousand bucks, that can get a little frustrating, and if you don't like to borrow money, which I never liked to borrow money, so I was always coming up with more ideas than I had money. So I had to sell whatever I liked least to buy something new that just was compelling to me."
For a long time, I was in that mode. Now our problem is we have more money than ideas. As Warren Buffett likes to say, when he was younger and had less money, he made more good investment ideas than money to actually make those investments. Over time, his portfolio has grown from hundreds of thousands of dollars to millions of dollars to billions of dollars, now to hundreds of billions of dollars. Currently, Warren Buffett has the opposite problem: He has more money than he has good investment ideas.
But for those of us who aren't managing a portfolio of stocks worth over $300 billion, like Buffett, we don't have the problem of having too much money to invest. Instead, we have a limited amount of capital and tons of potential investment ideas. This brings us to one of the most important concepts in all of investing and finance. That concept is opportunity cost. Put simply, this means that if you have your money invested in stock A, you can't also have that same money invested in stock B.
This means that you sometimes have to sell one good investment to then turn around and invest that money in an even better investment. I actually faced this opportunity cost dilemma just a few months ago. Someone I know was looking to sell one of their investment properties. After analyzing this rental, I determined that my annual returns on this investment property would likely be in the range of 20% to 25%.
After factoring in rent collected, debt paydown, price appreciation, and the tax benefits of owning real estate, as well as the expenses of maintaining and paying a property manager to manage the property. Now, of course, with those types of returns, I was interested. I just had one problem: In order to fund this purchase, I would have to sell a portion of my stock holdings, including even some of my beloved Berkshire Hathaway shares. This is a classic case of opportunity cost.
The decision I made was to sell a portion of my stock portfolio in order to fund the purchase of the property. This is because I determined that the return I was likely to receive on the investment property was higher than the returns I expected on my stock portfolio.
Warren Buffett frequently faced this concept of opportunity cost when he was younger and managing less money. Warren Buffett and the company he runs, Berkshire Hathaway, now own 100% of the insurance company Geico. But believe it or not, Warren's history with Geico dates back before Berkshire Hathaway. When Warren was a graduate student at Columbia Business School, while a student, Warren learned about Geico and subsequently put ten thousand dollars into Geico stock—around fifty percent of his net worth at the time. He held those shares for just over a year and then sold for a nice fifty percent gain. Why did he sell? Because he found an even better investment opportunity.
The next reason why Buffett would sell a stock is when the fundamentals of the underlying business change significantly. Let's listen to what he has to say: "Our inclination is not to sell things unless we get really discouraged, perhaps with the management, or we think the economic characteristics of the business change in a big way. I mean, and that happens."
A perfect example of changing economic conditions would be the newspaper industry. Buffett, through his conglomerate Berkshire Hathaway, has owned the Buffalo News, the newspaper of the town of Buffalo, New York, since 1977. At one point in time, Buffett even went as far as to call the newspaper business one of the best business models in the world. Think about the economic characteristics of a newspaper in the 1970s. If that newspaper was the dominant or only newspaper in town, that newspaper had essentially a legalized monopoly.
All the households within the town would have to subscribe to that newspaper in order to do everything from staying up to date on current events, following the local sports team, or even just finding a job in the classified section of the paper. Additionally, since the newspaper was read by nearly every household in the area, that made the paper very attractive for businesses that wanted to advertise and find potential customers. The newspaper could charge advertisers extremely high rates for ads for one simple reason: If local businesses wanted to reach a broad section of the local population in their advertising, they had no choice but to advertise in the newspaper.
As I'm sure you can imagine, this combination of distribution density and high advertising rates made newspapers very profitable businesses. This all changed as a result of one big secular shift: the rise of the internet. Now people no longer have to subscribe to the newspaper to get news, find a job, or stay involved in their local community. As people stopped subscribing to newspapers, that made advertising in newspapers less attractive, and ad rates fell. Additionally, businesses no longer had to rely on newspapers to reach potential customers. The rise of the internet opened up an entire new industry of online ads called digital advertising.
The decline of the newspaper industry is one of the greatest changes in the economic characteristics of any industry during Buffett's investing career. He even sold the 31 newspapers he owned in early 2020. This sale included the Buffalo News, formerly one of the best businesses Buffett owned. While Buffett frequently talks about how his favorite holding period is forever, I think there needs to be an asterisk added to that: as long as the economic characteristics of the business remain favorable.
When a stock we own falls 20%, 30%, even 40%, we have to ask ourselves one very important question: Has the economic characteristics of the business truly changed to justify this drop in stock value? If the answer is no, it may be a great buying opportunity to purchase even more shares. But if the answer is yes, it may be time to consider selling.
Finally, if you know Buffett, you know he is perfectly fine with a very concentrated portfolio. Heck, even Berkshire Hathaway's stock portfolio is nearly $340 billion, and yet 45% of this portfolio is concentrated in Apple stock. This brings us to the third reason of when you should sell: When a single holding becomes too large a percentage of your portfolio.
If you look at Buffett's investing career before Berkshire Hathaway, he ran what would be referred to in modern terminology as a hedge fund. In this fund, he had a rule where no single stock could be more than 40% of the portfolio. Buffett encountered what would be a quality problem to have: One of his largest positions in the fund, American Express, had performed so well that it actually hit the 40% threshold, and he was forced to trim his stake in the company—not because anything better had come along or because the economic fundamentals had changed, but simply because the position was too big a portion of the overall stock portfolio.
Now, this video up until this point has been all about when you should sell a stock. But real quick, I want to touch briefly on why you should have a preference for holding for the long term and why the best holding period is forever. This has to do with everyone's favorite thing: taxes. I hope you get the sarcasm in that phrase. Let's show why holding over a period is better than consistently buying and selling stocks.
Let's say, in this example, we have two investors: Investor A and Investor B. Let's assume both investors are able to get a pre-tax return on their investments of 10% a year. The only difference between the two investors is that Investor B sells the stock at the end of each year and, as a result, has to pay taxes on those gains throughout the year. Let's assume that tax rate is 30%. On the other hand, Investor A holds that stock for the entire 10-year period and only sells at the end of year 10.
He pays the 30% tax rate at the end of year 10 on all of his gains throughout the 10 years. At first, you may think that since both investors had the same pre-tax investment return and the same tax rate, they would end up with the same amount of money at the end of year 10. But this is not the case.
Investor A, who held for the 10-year period and only had to pay taxes on his gains at the end of year 10, had $21,156 after paying the taxes at year 10. Investor B, who sold each year and, as a result, had to pay taxes on his gains every year, had $19,672. If this experiment extended for 20, 30, or even 40 years, the difference between the two investors would be even larger.
This is why you should have a bias towards never selling, all else being equal, because, as this example illustrates, it is much more tax efficient than constantly buying and selling different stocks.
So now, to recap the main takeaways I want you to learn from this video: According to Buffett, there are three valid reasons to sell a stock: 1) You have found an even better investment, 2) The underlying fundamentals of the business have changed, and 3) One stock has become too large of a percentage of your portfolio than you are comfortable with.
Those are the three reasons to sell a stock. But keep in mind, ideally, you want to have an inclination to hold and not sell, all else being equal. This is because, as the earlier example illustrates, it is much more efficient to pay taxes once at the end of a long holding period than every year.
If you are interested in seeing what stocks I own in my personal portfolio, as well as having access to the tools I use to analyze stocks, make sure to check out my Patreon, because this is where I post all the tools I use to analyze stocks. Thanks for watching. If you like this video, you may also like the video right here. As always, make sure to like and subscribe to the Investor Center, because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you soon.