6 Benefits of Dumping a Losing Stock

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Let's be honest — losing money in the stock market isn't fun. Plus, prolonged stock under-performance can undermine your investment strategy. But often, investors really don't know when to sell or when to hold and wait out a storm. Market volatility makes it necessary for every investor to have an exit strategy. Here's how to know when to dump an under-performing stock. (See also: 4 Quick Ways to Decide if a Company Is Worth Your Investment)

1. It's Headed for Bubble Territory

Unusually high returns could mean a stock is headed for bubble territory. True, some stocks (Apple, anyone?) are just perennial winners. Typically, however, the party doesn't last forever, and what goes up must eventually come down. At the end of the year, consider selling off shares of exceptionally well-performing stocks to rebalance your portfolio's asset allocation and return it to its original allotted positions.

2. The Stock Is Overvalued

Before you dump a stock, check its price/earnings ratio (P/E ratio). The P/E ratio will reveal investor confidence in a company's stock and what they are willing to pay relative to the company's actual earnings. To calculate the P/E ratio — divide the company's stock price by its earnings per share. The standard P/E ratio is anywhere from 15-30. Over 30 is an indicator the company might be overvalued. The P/E ratio can be found on websites like Morningstar and Marketwatch.

Another way to value a stock is by calculating the company's cash flow ratio. To do this, simply divide the cash flow from operations by its current liabilities. The cash flow should be consistent with that of similar companies. If it's higher, it's probably overvalued. Some say this is a better performance measure. This information usually can also be found on the aforementioned financial websites.

3. The Stock Underperforms for Consecutive Years

If a stock experiences prolonged losses for a number of consecutive years, it may be that Wall Street knows something that you don't. It might be time to sell.

4. A New Fund Manager

Mutual funds sometimes hire new fund managers may who may have a different investment philosophy than the previous fund manager. At the end of every year, take a look a the assets within your funds. If you notice shifts to its asset allocation — such as being weighed more heavily to large cap stocks than before — this could indicate a change to the fund's strategy. If you're uncomfortable with any changes because they are out of alignment with your investment goals, dump the fund.

5. Capital Losses Eclipse Gains

When your capital losses exceed your capital gains, it may make sense to dump an under-performing stock. You can deduct up to $3,000 a year against your income and carry over up to $3,000 into following years. But do wait to make a decision until the end of the year. And be mindful of the "watch/sell" rule that prohibits investors from purchasing the stock or similar investments 30 days before or after the sale.

6. Volatility Is Keeping You Up at Night

Some market conditions are almost unbearable to withstand. Sharp fluctuations are not worth the gamble if they affect your health, or if your investment goals are short-term — such as for those relying on income from their investments.

How do you decide whether to sell a stock or fund?