Earlier in the week I railed against “timing the market”.
Timing the market means moving your money in and out of the overall stock market when you think the overall market looks cheap, or expensive. I said that trying to time the market costs investors a lot of money, maybe a third of their total pot.
That’s all well and good when it comes to the overall stock market. But what about individual stocks? How long should you hold individual stocks for, and when if ever should you sell?
The answer depends on your investing style. Warren Buffett for example likes to buy entire companies, on the cheap. And then he likes to wring income out of those businesses. He says that when you buy a share, you should plan never to sell it.
That obviously works for him! But with respect to the great man, it’s probably not the right answer for you. Here’s what you should do instead.
The weird law of penny share returns
Penny shares are weird. They don’t behave like shares in ordinary companies. They’re weird in a couple of different ways: for one, the data shows that they return more than big companies (you’re probably sick of me banging on about that). Another weird thing is that their returns follow a power law distribution.
What’s a power law distribution? Well it means that a very small number of the penny shares in your portfolio will make you most of your profits.
When everything comes together for a small company it can grow very very quickly. There’s nothing stopping a superstar penny share from growing 10x, 20x or even more. That’s just not possible for a bigger company. Big things can’t grow as quickly as small things.
Marc Andreessen is a venture capitalist – his job to find and invest in promising small companies. Here’s how he described power law distributions:
“Actual [venture capital] returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.”
… about ~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns.”
Your success or failure as a penny share investor depends on your ability to find a small number of really excellent companies. The big winners are the ones that make your investment career.
So, back to my original question – when should you sell a penny share?
Sage words from Babe Ruth
The important thing to remember here is that the superstar shares – investments that return 10x and higher – can take years before they’re done growing. You need to let those winners run, and you need to be patient with them.
Take the clothes retailer Next for example, a superstar share if ever there was one. Next is up almost 800% since 2008. If you’ve been lucky enough to be invested in Next since 2008, you’ve had to spend years resisting the urge to take profits.
And what about the other penny shares in your portfolio, the investments that didn’t quite make it to the big time? They don’t get the same level of patience. They haven’t earned it!
Shares which aren’t doing it should be chopped from your portfolio to make space for the next potential superstar. So how long should you give them? There’s no hard and fast rule here since every company progresses differently. But within a year you usually have a good idea whether or not a company is on the right track.
So there you have it. I’ll leave you with the words of Babe Ruth, noted penny share investor:
“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.”*