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Course 303
When to Sell an Investment



When the Dow Jones Industrial Average plunges 500 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 parameters 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.

If you haven't developed your monitoring procedures or created your Investment Policy Statement, review Portfolio 108 and download Morningstar's Investment Policy Statement Worksheet at (Note: The worksheet is available as a PDF file. You will need Adobe® Acrobat® Reader to view and print it.)

This course 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.

How Selling Can Hurt

Sticking with a good long-term investment is better than trading in an out as it goes up or down. The problem is timing. Investments can make big gains and losses in a short period of time, but it's impossible to predict such short-term movements. The challenge isn't unique to investors trying to pick the "right time" to buy a particular stock. Studies show that it's tough to time the broad market, too.

If you've done the homework necessary to find a good stock or fund, just stick with it. Timing an investment's highs and lows is nearly impossible to do.

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 gotten 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 Portfolio 104.

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 stock price or a fund's performance from long-term shifts in fundamentals.

Let's say that because of a change in foreign-exchange rates, Coca-Cola (KO) 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 mutual 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 grill 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 Mutual Funds and Stocks tracks of the Investing Classroom can teach you how.

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 mutual 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, mutual 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 five years ago, 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 today. More than likely, either large-company stocks have outperformed smaller companies during that time (or vice versa), or one style has dominated over the other. That once-balanced portfolio is likely out of whack today.

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.

We cover how to rebalance a portfolio in Portfolio 305.

A better opportunity comes along.
Suppose the stock of a great company that you've been keeping your eye on suddenly drops. Or say a mutual 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 jeopardize 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 stock fund. Your goal and the time until you draw on your investment have changed. The investment should, too.


Quiz 303
There is only one correct answer to each question.

  1 Which is the best strategy for long-term investors?
    a. Sticking with a good long-term investment
    b. Trading in and out of an investment as it goes up or down
    c. Selling an investment when it rises by 25%
  2 Which is not a good reason to sell an investment?
    a. Your goals have changed.
    b. The investment's fundamentals have changed.
    c. You need the money.
  3 What should you derive your sell parameters from?
    a. The price movements of your investments
    b. The investment philosophy and investment selection criteria you laid out in your Investment Policy Statement
    c. How badly you need the cash
  4 When has an investment become too expensive?
    a. When its price has risen by 25%
    b. When its stock price is running well ahead of the company's earnings
    c. There are no hard and fast rules about what's "too expensive"--that's up to you.
  5 You're investing for retirement in 25 years. You decide to use some of those saved-up retirement dollars for a new goal: paying for part of your 15-year-old nephew's college education in three years. What should you do to your portfolio?
    a. Nothing.
    b. Consider selling some of the long-term securities and investing the proceeds in shorter-term investments to fund your new goal.
    c. Begin trading in and out of your long-term investments as their prices move up and down--you don't have time to spare.
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