A simple formula to decide when to sell or buy shares

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This article would be useful to those who invest or want to invest in both equity and debt financial instruments and use the money to build a large corpus either for retirement or to buy something that is expensive. The time horizon would be of the order of multiple years and the individual time available to do research and take a buy or sell decision would be limited. Although this might seem like too many conditions but I believe this would cover a large set of folks, so I thought I would share my formulae so that the readers have one more perspective to investment strategy. The readers would then have one more option in their bucket to either choose to implement or ignore this strategy. Knowing more options only has upside since you can always choose to ignore the option. I use this formula personally to automate some of my decision as I don’t have time to research and figure out when to buy and sell.

Now let me talk about the problem statement. As many of you would already know that investment is a very critical aspect of future financial planning. We work and we get paid and at some at some point of time we either would not like to work or we won’t be able to work (e.g. health issue). So, we all need to prepare for retirement. Every country has different instruments available to enable tension free retirement but in this article, I would like to talk about one of the key instrument and that is equity. Investment in stocks either directly or indirectly via mutual funds is one of the most lucrative investment as it can give very high returns. Stocks also have high liquidity and low entry and exit barrier. It comes with its own risk but the risk can be managed by choosing the right stocks. So, this would lead to two questions, how do I choose the right stock and when should I buy or sell. Both the questions are very important. However, in this article, I would like to share my opinion on the latter part.

Even if you have chosen the right stock, over a long period of time the share price of that company would go up and down. This could be because of multiple reasons including the financial result of the company or the stock market influence. The idea is to sell when the prices are relatively higher while buy when the price is relatively low. This would translate to selling and buying at regular interval. The later part of this article would focus on not only how you can take a decision but also how you can potentially automate the process.

Before we talk about the decision-making process, I would like again talk about debt and equity. As I mentioned earlier equity has high rewards but they come with their own risk and in the life cycle of a share very likely the prices would go up and down. So, if the prices of shares are down we should be in a situation where we have sufficient money parked somewhere which can be used to buy more shares. This brings us to debt. In debt instrument, the risk is low and so is the return. The debt market would not help you gain any significant financial advantage but would prevent any inflation related loss to your fund. This would mean that even if the stock market crashes, the debt instrument would still continue to earn money. So, if we can create a fund where we maintain a ratio between equity and debt, when the share prices are high, we can sell the shares and park the value in debt funds. While when the value of shares is running low then we can move the money from debt fund to equity. Of course, this comes with an assumption that in the long run equity would be a winner. Historically this has always been true. Stock market have crashed and have recovered every time for large part of the world.

So, the first question would be what should be the ratio between debt and equity. The answer is nobody knows the exact value but if you can take more risk than your equity contribution should be more than debt and if you are not ok to take more risks then your debt contribution should be more. The formulae that I use is that if you are in your 20’s then equity contribution should be 80% as you have more time and cost of failure would be low. Then as you age, increase your contribution by 10% every decade. This means that when you are in your 30’s, park 30% of your money in debt. This would translate to more risks and probably more rewards early in your life which would help you make your overall corpus bigger while less risks and assured income towards latter period of your life as the contribution of safe debt fund would be significantly higher as you age. I believe everyone would agree that nobody would want high volatility in your income when you are retired.
Now since we have a formula, let’s talk about when you should sell and buy given that you have taken a decision about a stock. The answer lies in the ratio itself. Every six months you can do an analysis of your portfolio and see what is the equity to debt ratio. Based on recommend ratio that you have set for yourself, you just need to calculate where you are spilling and then take a corresponding decision of sell or buy. Assume that equity to debt ratio is 85%:15% and that you have set a ratio of 70:30, your portfolio is now unbalanced. So, you need to sell 15% of your stock and move the fund to debt instruments. Once you have taken this decision, you would then need to find the right stock which you need to sell and the right one would be the list of stocks in your portfolio which is giving you most profit. So, you can apply the ratio and sell part of your stock which is making you profit and move it to debt.

Just to make things clearer, let’s understand the strategy with an example. Above is the chart of a stock in 5 years. Like any, the stock has its high and low. As discussed, ideally, I would like to sell when the stock is high and buy when the stock is low. Now assume that I have bought 100 stocks in 2012. If I do an evaluation after 6 months, then the stock has increased but the increase is minimal. There can be two cases right now, the overall equity contribution is higher which means that you have to sell stock or the overall equity contribution is lower when you have to buy stock. The likelihood of this being the first case is very low since the stock value has not increased and the ratio should be in tack or not in favor of stock unless there are more stocks in your portfolio which is making significant profit. In that case you sell those stock and leave this. Now let’s go to mid of 2013, when the stock value is very low and you are in a loss. If this is the only stock then automatically your debt contribution would be higher, which would mean that you have to sell your debt investment and push money in stock. The only way your equity contribution would be higher would be because of some other stock doing well. In this case you have two choices, sell the shares which is yielding high return and buy this share or buy debt fund. As per the formulae, the suggested action would be buy debt fund. I believe this is the right choice. The reason is very simple. If most of your stocks are doing well and some of them are not then it’s better to evaluate whether you should continue with the one which is not doing well. If you don’t book profit and move the fund to another equity then you might lose that profit as well. If you book the profit, you would have taken advantage of the situation.
Assuming the most probable scenario above, you would either buy when the share is low and sell when the share is high thereby increasing your chance of booking profit and increasing your corpus value. If you do a simple calculation when you buy at low and sell at high, your overall profit would be significantly higher than a simple one-time investment when you buy share and wait for the prices to go higher. The overhead of taking the decision is also very simple, thus the time investment from your side would also be very trivial.

Hope this helps. Happy investing!!