I thought for a bit and told him to hold on. But I didn't do a great job at explaining why.
After thinking some more, I came up with the three rules below. They may sound familiar. But bear with me because I arrived at this answer by distilling a few things I've experienced, learned, and believe in; not by repeating what others have written. If my rules sound similar, well, I won't get credit for being the first one to write about them.
So, here's a better answer to "when to sell". Sell when:
- The price has surpassed intrinsic value.
- Fundamentals have changed.
- When you are bored in a rallying market.
I usually sell bonds or bond funds when price is above par and I have doubts about the fundamentals (see also item 2. below). I never buy bonds at par, I always insist on a discount, no matter what the "fair market value" might be. But this is just me. Therefore, to remain consistent, I begin considering selling my bonds when they reach or go above par. If I'm positive of their fundamentals and the yield is still attractive (which, at an above par price they seldom are), then I may hold on for a little bit longer. But if the price gets ahead of par plus future coupons discounted, then the bond is gone.
For stocks, this rule is hard to apply. I usually start with rule 2. below. But if prices get too bubbly, I'll will probably sell at least my weaker companies.
Fundamentals have changed. If my estimates of the prospects of a company change, I usually reassess the value of my holdings. If the new intrinsic value is below the current price, then rule number 1. above dictates I should sell. It's that simple.
Reasons why fundamentals change abound. A few examples: critical management leaves on bad terms; the annual or quarterly report becomes hard to decipher; fraud is found to be pervasive within management; the assumptions about future prospects change materially.
One reason I usually don't worry much is if a product or line of products fails to materialize. That's because I mostly ignore promises of future products in my analyzes. So a new drug not being approved by the FDA should not have a material effect on my analysis of a pharmaceutical company, even though it typically does for Wall Street analysts. The same is true of new "hot" products such as Apple's next iPhone or whatever else tech companies might have promised investors.
When you are bored in a rallying market. I know this is controversial, but let's be honest, everyone gets overconfident sometimes. Saying you shouldn't time the market is good advice, but it's almost impossible to follow. So let's make sure that if you do time the market, that at least you don't attempt to pick bottoms or tops, but that you simply have a profit and a reason to sell.
Originally, I was going to write this rule as "when you need to raise cash in a rallying market". But what is needing to raise cash if not being bored with the returns on your portfolio? Sure, emergencies. But that aside, raising cash usually means you found other investments that may be more attractive.
So, it's fine to rotate out of some investments if the market is rallying, you're ahead and you've found something better. The rule is: a) the market is going up and b) you have gains in the securities you want to sell and c) you have a more attractive investment to make and d) you follow the rules for buying (more on that later).
That way, you avoid: a) selling at major bottoms, b) losing money, c) limiting your gains, and d) buying without a reason.
And that's the only time you're allowed to be so foolish as to try to time the market or sell for a bad reason (being bored).
But let me re-iterate the third rule again: when you're bored and trying to time the market at least make sure the market is in your favor -- sell high -- sell during market rallies at a gain, never at a loss. Then, make sure you have something else in mind. Cash is not an option. Taking your gains just because you have them doesn't make sense. After all, if you did your homework right, you should expect to have even larger gains in the future. So sell only because you've found something better. And again, at a profit.
I hope my fellow investor didn't sell his bonds, but that if he did, he sold them at a gain to immediately buy something better, perhaps an undervalued stock of a profitable and growing company.
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