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While the media and most books talk about how to pick stocks and make money, I want to talk about the other side of the trade; when to walk away from an investment. A lot of financial literature talks about the benefits of holding on to investments over the long-term, with examples of millions made over the course of 30-40 years on a few small investments so investors are sometimes tempted to just blindly take a buy-and-hold approach to their investments.
People are also emotionally inclined to be optimistic about their investments, believing in the company and its strategy, often times riding losing stocks all the way to the bottom… and that hurts your portfolio big time. Buy-and-hold is an excellent way to make money provided you’ve picked the right company for this winning strategy to play out, but not all companies grow successfully over time. Many, instead, have a few good years but ultimately succumb to competition or internal incompetencies.
It’s important to talk about when it’s okay to walk away from an investment that you so carefully made and believe in. This topic is also nicely covered in a recent article by Jon Stein in Betterment.com.
While we hear about Warren Buffett and a host of less famous citizen-investors who socked away their money in a few solid names and made fortunes, American financier Bernard Baruch – who made his fortune in the early 20th century – says the secret of his success was that “he always sold too early” – which is pretty counter-intuitive relative to the buy-and-hold way of getting rich.
But what Bernard Baruch is really saying is that he never tried to time the market, he never tried to wait till shares hit their peak, but always got out when he believed he’d gotten a satisfactory return and shares had gotten to a level where they offered little “real” upside… so he never played the momentum game of riding a stock even after it had gotten ahead of its fundamentals.
Baruch’s statement is also a good cautionary reminder that market timing is tricky business. Investors tend to get emotional when they see highs and lows in the market — selling on impulse, rather than strategy, and thinking they can time the market. So don’t waste your time trying to hone your market-timing skills – that strategy fails most of the time.
For decades, research has shown that emotionally driven trading leads to a huge gap in investor performance, and vigorous trading to catch the market at just the right moment is one of the worst things an investor can do.
The Good Reasons to Walk Away
First, the real reason to sell and switch investments is to move into something better. The question to ask before selling an asset is; what am I going to replace this with? So, for example, it may be worthwhile to sell a mutual fund, even one intended to be a core, long-term holding, if its management fees and other expenses are higher than those of similar funds with the same investment objectives. Replacing it with a cheaper, more diversified, and more tax-efficient mutual fund or ETF can make a lot of sense.
Chasing short-term performance is always a bad idea, and selling recent losers and buying recent winners is not a good investment strategy. In fact, data from Morningstar shows that funds that perform well in one year have no more than a 56% chance of doing better than average in the following year… and funds that perform poorly in a given year have only a 48% probability of beating the market the next year – so the odds that winners will win again aren’t that different from the odds that your losing shares might gain – so save yourself the trouble of flipping in and out of funds, chasing winners, because you’ll unnecessarily pay trading fees and commissions and could also be on the hook for hefty short-term capital gains from selling the old fund.
Don’t let emotions drive you to sell.
Here’s another data-point… research has shown that a significant problem with the decision to sell — especially individual securities – has nothing to do with costs, and instead has a lot to do with emotions. I’ve spoken about this before… it’s called Loss Aversion, a well-known psychological behavior where we feel the pain of losing more strongly than the pleasure of winning an equivalent amount. For example, in a study, participants refused to stake $10 on the toss of a coin if they stood to win less than $30 – so the aversion to losing is so strong that people often knowingly leave money on the table in order to avoid a sense of loss.
And this plays a big role in investor behavior; investors have a (bad) habit of selling winners because Locking-in a gain feels good and On the flip side, realizing a loss can feel like we made a mistake and had to pay for it. And investors want to avoid taking the loss and hope that a losing stock will ‘come back’… so they hold on to their losers… and pay the price.
Both of these strategies can cause you to lose out on the returns you’re looking to make.
Selling winners and holding on to losers is also inefficient from a tax standpoint because you end up paying taxes on your gains without having “realized losses” to offset those gains – so your overall tax payout is much higher if you sell winners and continue to hang on to your losing stocks.
Another reason not to sell winners is that the trend can be your friend. Strong performers can keep rising. And trends works in the other direction too – assets that have lost value may continue to do so.
Hanging on to winners allows gains to accumulate and defers taxes on them, while selling investments that aren’t living up to expectations can prevent losses from mounting. Once they do mount, another quirk of human nature comes into play, one that Baruch alluded to: the tendency for stubbornness to give way to panic, leading investors to dump their holdings at a bottom.
Strategic selling: Rebalance or tax loss harvest
One of the few sensible reasons to sell winners is to rebalance your portfolio. Rebalancing involves disposing of portfolio holdings in asset classes that have risen in value, and using the proceeds to buy more of your asset classes that have risen less in order to restore a balance between stocks and bonds.
Without rebalancing, you could end up having more of your portfolio’s market value in stocks that are typically more volatile than bonds… so it makes sense to look at your asset allocations from time to time, take stock of your market valuation gains and consider rebalancing some of your portfolio as part of a rational and scheduled strategy.
For example, we all know equities have done really well over the past few years, so any time there’s a significant run of outperformance by one asset class over the other, it makes sense to look at your asset allocation and consider rebalancing. As I’ve mentioned before, there are several services that offer automatic rebalancing and may be worth looking into.
Tax loss harvesting is another good reason to sell a losing asset, provided you replace it with something that offers similar risk. At its most basic level, tax loss harvesting is selling a security that has experienced a loss — and then immediately buying a correlated asset (one that provides similar exposure, ideally in the same asset class) to replace it. This strategy allows the investor to realize a loss, which can be useful to reduce or defer a tax liability, while keeping the portfolio balanced at the desired allocation.
Back to Bernard Baruch – he became a Wall Street legend by making a killing in the stock market. But he did so by carefully managing risk and growing his wealth by selling appreciated assets and quickly dumping losers… remember, he said he sold too quickly! So take a leaf from his book and develop a strategy where you sell your securities in a systematic, disciplined way to stay properly diversified.
In a nut shell, trend can be your friend; don’t try and overly time the market; when you’ve had a good run with one asset class, consider rebalancing your portfolio to reduce risk; use tools such as automatic rebalancing and, finally, as much as you can, try to keep your emotions out of the decision-making process.
