What's the hardest part of the investment process?

If you said choosing the right stocks to buy, you'd be wrong.
In my opinion, the hardest part of the investment process is knowing when to sell.

Why is selling stocks so difficult?

One reason is that investors often have no idea why they bought a stock in the first place. So if you don't know why you bought, you'll have a tough time knowing when to sell.

Selling stocks exposes you to a number of potential problems. First, every time you sell, you incur a transaction cost. Transaction costs whittle down the value of your portfolio.

Another problem with selling stocks is that you may incur a tax liability. And if you held the investment less than 12 months, your profit is taxed at your ordinary income tax rate and receives no favorable capital-gains treatment.

Perhaps the biggest problem with selling is that you have to do something with the sale proceeds. If you keep the proceeds on the sideline, you are not maximizing the power of time in your investment program. And if you put the proceeds into another investment, chances are that the new investment won't do any better - and could do a lot worse - than the investment you sold. The risk that what you buy won't do any better than what you sold is called "reinvestment risk."

So when should an investor sell?

One reason to sell is because the reasons you bought the stock didn't pan out. This reason puts a big premium on knowing why you bought the stock in the first place. What I have found useful over the years is to write down the reasons for buying a stock. When I know why I buy something, it's much easier to sell something if my reasons for buying don't come to fruition.

Another reason to sell a stock is because the company's financial position is deteriorating. How can you tell a company's finances are weakening? One way is to look at the firm's long-term debt level as a percentage of total capital (total capital is long-term debt plus shareholders' equity). Rising debt levels as a percentage of total capital may be indicating financial trouble.

Finally, if your company makes what I call a "stupid" acquisition - perhaps the firm buys a company outside its primary area of expertise - that may be a reason to sell. Indeed, a lot of academic work has shown that mergers don't usually provide a lot of value for shareholders.

However, while good reasons exist to sell stock, they are few and far between. In fact, I maintain that if investors bought every stock with the idea that they could never sell it, they would make much smarter investment decisions.