Investing Classroom: When to sell an investment
Portfolio lesson 3.3: There are good reasons and bad reasons to sell an investment and it's important to know the difference
When the FTSE 100 index plunges 200 points in a single day, the
knee-jerk reaction is to get out--fast. But just as making an investment occurs
only after of an extended period of goal setting and research, selling is also
best done only after cool deliberation. Selling is not best done in the heat of
crumbling markets.
Develop your selling discipline. That means establishing a set of selling parametres for your investments. Selling according to pre-established rules forces you to have a good reason for getting out of an investment--a reason that's based on your personal investment philosophy and the investment selection criteria you laid out in your Investment Policy Statement.
This lesson will cover how selling can hurt a portfolio's performances, some bad reasons to sell an investment, and some good causes for pulling the trigger.
Bad reasons to sell
Maybe you're not a timer, at least not consciously. But you may be prone to sell an investment for the wrong reasons. Any of these bad reasons sound familiar?
The investment has lost a lot: Despite the attention lavished on the ups and downs of an investment's price, an investment's price movement doesn't tell you much about the investment's future prospects. Let's say you own a stock or fund that's got crushed. It's tempting to sell, right? But think about it: What good does it do to sell after the investment has fallen? Whatever the bad news was (if there was any), it has already been incorporated in the investment's price. The more rational reaction to a drop in an investment's price is often exactly the opposite of a sale: If you really like the investment, perhaps you should take advantage of the lower price to buy more. You're almost certain to make more money in the long run if you ignore what other investors are doing. That means ignoring price movements. Selling only turns paper losses into actual losses.
The investment has gained a lot: Likewise, just because an investment has risen is no reason to sell. It's oh-so-easy to sell (or fail to buy) a great investment simply because it has already had a good run: It has to peter out, right? But myriad examples show that no, investments don't have to peter out. The fact is, most investors would be better off if they tuned out daily market updates. That's just noise that, if listened to, can interfere with your long-term investment success.
You need the money: Selling because you need the money--regardless of how your investments are doing--is a terrible position to be in and one you should avoid at all costs. Before you invest in stocks or funds, make sure you have an emergency stash in an easy-to-access savings or money-market account to cover unexpected car repairs or sudden unemployment.
For more about how to establish an emergency fund, review this earlier portfolio lesson.
Good reasons to sell
Of course, it’s unlikely you'll hold most investments forever. You will need to sell investments from time to time. Just make sure you're selling for a good reason--and your reason should stem from your own investment philosophy and your investment-selection criteria.
The fundamentals of the investment change: It's often tough to distinguish between the normal fluctuations of a company's share price or a fund's performance from long-term shifts in fundamentals. Let's say that because of a change in foreign-exchange rates, Cadbury earns a little less than analysts had expected in a given quarter and the stock's price takes a licking. Who cares? The company's long-term prospects aren't damaged.
But if the changes are deep enough, the reasons you bought the investment may no longer hold. Then, you'd consider selling. Maybe you own a stock because the company is growing rapidly. But you find out about accounting irregularities at the company, which pull the rug out from under profits. You may still want to own the stock, but only if you're interested in turnarounds it's no longer a growth stock.
The fundamentals can change with funds, too. Presumably, you buy a small-value fund because you want exposure to small-value stocks. If the manager starts buying large-growth stocks, you may have a problem. You may now have multiple large-growth funds in your portfolio, and no small-value fund. You may need to sell to restore your original balance of styles.
You made a mistake: Closely related to changing fundamentals are misunderstood fundamentals. If you buy a gas barbecue that won't light, or a shirt that doesn't fit, you return it. Sometimes investments need to be returned, too. Let's take an example. Suppose a bond fund loses more than 20% in a year in which its average peers suffer a much slimmer loss because it had made a big bet on emerging-markets debt. Shareholders who thought they were buying a boring multisector bond fund had every right to sell. They'd made a mistake. Rather than hang on to a mistake in the hope it stays above water, it makes sense to switch the money to a more compelling investment, one you feel comfortable with. The best way to avoid such situations, of course, is to be a finicky buyer. Research your investments thoroughly.
The investment becomes too expensive according to your criteria: There's no reason an investment that's done well can't continue to do well. But when valuations rise, the investment's price is outpacing the business--the P in the P/E ratio is rising faster than the E. If you invest in a stock or fund--not because you love the company or fund management but because the investment seems undervalued--a rise in valuations may mean it's time to move on.
Unfortunately, no hard-and-fast rules exist on when an investment becomes too expensive. That's up to you to determine as part of your investment philosophy. For most investors, however, funds don't become "too expensive" the same way stocks do. That's because fund managers are (theoretically, at least) selling the fully valued stocks in their portfolios and replacing them with better opportunities. They're defining what "too expensive" means, and they're weeding out pricey stocks based on their criteria.
Your portfolio needs rebalancing: Let's say you had a balanced portfolio at the end of 2007, with equal weightings in the four corners of the Morningstar style box--large value, large growth, small value, and small growth. Your portfolio probably wouldn't be balanced near the end of 2009, given the turmoil of the past two years. Prudence counsels spreading risks around, and that includes rebalancing a lopsided portfolio. For safety's sake, it pays to periodically check to see if your portfolio is diversified, with a good mix not only among styles, but among asset classes and sectors, too. That often means selling some winners and investing the proceeds in losers. This article tells you how to approach an end-of-year check-up of your portfolio.
A better opportunity comes along: Suppose the shares of a great company that you've been keeping your eye on suddenly drop, or say a fund that was closed for the past five years finally reopens. When too-good-to-pass-up opportunities arise, it may make sense to sell some of the least-compelling parts of your portfolio to fund the purchase. Just be sure that these opportunities are well thought-out and investigated, that they fit your long-term investment goals, and that they meet the investment selection criteria you laid out in your Investment Policy Statement.
The investment doesn't live up to expectations: While one year of underperformance may be nothing to worry about, two or three years of falling behind can get frustrating. Worse, if you're relying on the investment to offer a particular amount of return each year, on average, and it continually falls short, it may jeopardise your chances of meeting your financial goal. Before pulling the sell trigger, be sure you're comparing your underperformer to an appropriate benchmark, such as its Morningstar category, its industry peers, or a suitable index. Also, be sure that your investments continue to meet the other investment selection criteria in your Investment Policy Statement. If they don't, they may be sell candidates.
Your investment goals change: We don't invest to win some imaginary race, but to meet our financial goals. As your goals change, your investments should change as well. Suppose you start investing in a balanced fund with the goal of buying a house within the next five years. If you get married and your spouse already owns a house, you may decide to use that money for retirement instead. In that case, you might sell the balanced fund and buy a pure equity fund. If your goal and the time until you draw on your investment have changed, then so should your investment change too.
Develop your selling discipline. That means establishing a set of selling parametres for your investments. Selling according to pre-established rules forces you to have a good reason for getting out of an investment--a reason that's based on your personal investment philosophy and the investment selection criteria you laid out in your Investment Policy Statement.
This lesson will cover how selling can hurt a portfolio's performances, some bad reasons to sell an investment, and some good causes for pulling the trigger.
Bad reasons to sell
Maybe you're not a timer, at least not consciously. But you may be prone to sell an investment for the wrong reasons. Any of these bad reasons sound familiar?
The investment has lost a lot: Despite the attention lavished on the ups and downs of an investment's price, an investment's price movement doesn't tell you much about the investment's future prospects. Let's say you own a stock or fund that's got crushed. It's tempting to sell, right? But think about it: What good does it do to sell after the investment has fallen? Whatever the bad news was (if there was any), it has already been incorporated in the investment's price. The more rational reaction to a drop in an investment's price is often exactly the opposite of a sale: If you really like the investment, perhaps you should take advantage of the lower price to buy more. You're almost certain to make more money in the long run if you ignore what other investors are doing. That means ignoring price movements. Selling only turns paper losses into actual losses.
The investment has gained a lot: Likewise, just because an investment has risen is no reason to sell. It's oh-so-easy to sell (or fail to buy) a great investment simply because it has already had a good run: It has to peter out, right? But myriad examples show that no, investments don't have to peter out. The fact is, most investors would be better off if they tuned out daily market updates. That's just noise that, if listened to, can interfere with your long-term investment success.
You need the money: Selling because you need the money--regardless of how your investments are doing--is a terrible position to be in and one you should avoid at all costs. Before you invest in stocks or funds, make sure you have an emergency stash in an easy-to-access savings or money-market account to cover unexpected car repairs or sudden unemployment.
For more about how to establish an emergency fund, review this earlier portfolio lesson.
Good reasons to sell
Of course, it’s unlikely you'll hold most investments forever. You will need to sell investments from time to time. Just make sure you're selling for a good reason--and your reason should stem from your own investment philosophy and your investment-selection criteria.
The fundamentals of the investment change: It's often tough to distinguish between the normal fluctuations of a company's share price or a fund's performance from long-term shifts in fundamentals. Let's say that because of a change in foreign-exchange rates, Cadbury earns a little less than analysts had expected in a given quarter and the stock's price takes a licking. Who cares? The company's long-term prospects aren't damaged.
But if the changes are deep enough, the reasons you bought the investment may no longer hold. Then, you'd consider selling. Maybe you own a stock because the company is growing rapidly. But you find out about accounting irregularities at the company, which pull the rug out from under profits. You may still want to own the stock, but only if you're interested in turnarounds it's no longer a growth stock.
The fundamentals can change with funds, too. Presumably, you buy a small-value fund because you want exposure to small-value stocks. If the manager starts buying large-growth stocks, you may have a problem. You may now have multiple large-growth funds in your portfolio, and no small-value fund. You may need to sell to restore your original balance of styles.
You made a mistake: Closely related to changing fundamentals are misunderstood fundamentals. If you buy a gas barbecue that won't light, or a shirt that doesn't fit, you return it. Sometimes investments need to be returned, too. Let's take an example. Suppose a bond fund loses more than 20% in a year in which its average peers suffer a much slimmer loss because it had made a big bet on emerging-markets debt. Shareholders who thought they were buying a boring multisector bond fund had every right to sell. They'd made a mistake. Rather than hang on to a mistake in the hope it stays above water, it makes sense to switch the money to a more compelling investment, one you feel comfortable with. The best way to avoid such situations, of course, is to be a finicky buyer. Research your investments thoroughly.
The investment becomes too expensive according to your criteria: There's no reason an investment that's done well can't continue to do well. But when valuations rise, the investment's price is outpacing the business--the P in the P/E ratio is rising faster than the E. If you invest in a stock or fund--not because you love the company or fund management but because the investment seems undervalued--a rise in valuations may mean it's time to move on.
Unfortunately, no hard-and-fast rules exist on when an investment becomes too expensive. That's up to you to determine as part of your investment philosophy. For most investors, however, funds don't become "too expensive" the same way stocks do. That's because fund managers are (theoretically, at least) selling the fully valued stocks in their portfolios and replacing them with better opportunities. They're defining what "too expensive" means, and they're weeding out pricey stocks based on their criteria.
Your portfolio needs rebalancing: Let's say you had a balanced portfolio at the end of 2007, with equal weightings in the four corners of the Morningstar style box--large value, large growth, small value, and small growth. Your portfolio probably wouldn't be balanced near the end of 2009, given the turmoil of the past two years. Prudence counsels spreading risks around, and that includes rebalancing a lopsided portfolio. For safety's sake, it pays to periodically check to see if your portfolio is diversified, with a good mix not only among styles, but among asset classes and sectors, too. That often means selling some winners and investing the proceeds in losers. This article tells you how to approach an end-of-year check-up of your portfolio.
A better opportunity comes along: Suppose the shares of a great company that you've been keeping your eye on suddenly drop, or say a fund that was closed for the past five years finally reopens. When too-good-to-pass-up opportunities arise, it may make sense to sell some of the least-compelling parts of your portfolio to fund the purchase. Just be sure that these opportunities are well thought-out and investigated, that they fit your long-term investment goals, and that they meet the investment selection criteria you laid out in your Investment Policy Statement.
The investment doesn't live up to expectations: While one year of underperformance may be nothing to worry about, two or three years of falling behind can get frustrating. Worse, if you're relying on the investment to offer a particular amount of return each year, on average, and it continually falls short, it may jeopardise your chances of meeting your financial goal. Before pulling the sell trigger, be sure you're comparing your underperformer to an appropriate benchmark, such as its Morningstar category, its industry peers, or a suitable index. Also, be sure that your investments continue to meet the other investment selection criteria in your Investment Policy Statement. If they don't, they may be sell candidates.
Your investment goals change: We don't invest to win some imaginary race, but to meet our financial goals. As your goals change, your investments should change as well. Suppose you start investing in a balanced fund with the goal of buying a house within the next five years. If you get married and your spouse already owns a house, you may decide to use that money for retirement instead. In that case, you might sell the balanced fund and buy a pure equity fund. If your goal and the time until you draw on your investment have changed, then so should your investment change too.
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