Wednesday, September 01, 2010

A New Approach to Making Money: Buy and “Know when to sell”

By Rajiv Hargunani

The oldest adage on Wall Street is “Buy Low, Sell High”. We all are able to do one part very easily i.e. buy. Why do we have such a hard time selling? Why are we so afraid to sell? Why do we rarely see magazine covers or analysts telling you about the investments to sell right now? 

We have been trained to think that buying stocks is paramount to building wealth. It has almost become an addiction that we check our portfolio every single day, knowing fully well we may not need that money for years to come. Does the thought of selling make you an unbeliever in the markets? Why is the thought of selling so powerful, that we lose our ability to rationalize and make common sense decisions?

Selling is not easy if you don’t have a plan of action. You are constantly bombarded with information urging you to act. Your emotions of Fear and Greed are in control at that point and your action/inaction comes down to these emotions. If our investment has a loss, we wait (or in some cases hope) for it to come back to break-even so that we can get out without a loss. On the other hand, if our investments are making a ton of money, we let it ride, hoping to catch the absolute top. The fear of actually booking a loss appears to be more devastating than the pleasure of booking a solid gain.  If we can conquer these emotions and have a well written plan of action, the chances are, your investment returns will have fewer nasty surprises.

Looking back over the last 10-15 years as the dot-com era unfolded, how many times did we hear “this time is different” and that the internet was promising a “new economy”?  We are all guilty of ignoring fundamentals and holding on to the Tech bell weathers, believing the story and consequently paying the price. Was there a time where you should have sold some investments and rebalanced your portfolio? Are you repeating those mistakes again?

In a secular bull market like we had from 1982 – 2000, being in stocks was the way to go. It almost became taboo to think of selling.  Even in those times if you had periodically rebalanced your well diversified asset-allocated portfolio, you would not have taken a huge beating in the subsequent years as a buy-and-hold investor.

Let us take a look at one example from that time period, the biggest gains coming in the last part of the 90s. In 1999, Wal-Mart stock hit a price of $70 with earnings of $1.28 per share giving it a Price-to-Earnings (P/E) Ratio of 39 (Source: Value Line). Was the market pricing in the future earnings correctly or was it a case of too much optimism? Fast forward 11 years and the stock price is currently at $51 with a P/E ratio of about 14, more in line with its historical average. Similarly there are other examples, where had you done your homework you would have realized that maybe selling part of your holding would have reduced your risk.

As you analyze your portfolio, here are a few factors you should consider

1. What was the reason/objective you bought the stock? Has the objective been met? If the goal was to save, say $1 Million for your retirement, and you have achieved that target, it would be prudent to come up with a hedging strategy. This could be selling part of your riskier holdings and moving down the risk spectrum.
2. Has the investment (or asset class) had uncharacteristically good returns? Think about the late 90s, the stock market represented by the S&P 500, had spectacular returns 5 years in a row, providing returns in excess of 20% each year. The returns were much higher than the median returns over the past 80 years. That would be a good sign again to lighten up on your riskier assets. 
3. Conquer your emotions. Don’t let fear or greed become the primary factors in making your investment decision. 
4. It is never all or nothing. Selling does not necessarily mean off loading the entire position. With the correct asset allocation - periodic rebalancing will force you to sell some of the winners and move into the assets that have been underperforming. That way you are always in the game, and what you have achieved by rebalancing, is reducing risk in your portfolio. For example, say you started out with a portfolio split 60-40 between Equities and Fixed Income. As the 90s bull market roared on, the gains in equities would have forced you to sell some and invest those proceeds in the fixed income bucket in order to keep your portfolio at 60-40. As the tech bubble burst and the markets headed lower, the fixed income portion started outperforming equities in the early part of this decade and we could have repeated this entire cycle over the next 7 years. What this provided you was a higher risk-adjusted return than the traditional buy and hold approach. 
5. Taxes – When you sell some of your investments, there are tax consequences you need to be aware of. However, the thought of paying taxes should not be the overriding reason for not selling a position if that’s the right thing to do at that time.

I am not advocating a total rejection of buy and hold. However, when you listen to analysts and pundits who constantly preach this, what they forget to tell you is that the time frame for their suggestion is usually very far in the future. We have been told that (buying) investing in the markets (in general) has been the best way to build wealth. However, the point to consider is that each one of us has a fixed time period to accumulate wealth in the hope of achieving our objective, be it saving for college or for retirement.  Since the beginning of this decade, the markets have given us negative returns, giving a lot of baby boomers a significantly less rosy retirement than what they had in mind after the 90s bull market.

Another example is the Japanese stock market represented by the Nikkei 225 Index. (Chart: Yahoo! Finance)

As of this writing, it is down about 75% from its high set in 1989. 21 years of investing that has produced negative returns over all. This goes to show us that time left to achieve our goal (for example, retirement) should not be a dominating factor in increasing the risk in your investment portfolio. That should be based on your risk tolerance, objectives, income, cash flow and liabilities amongst other things.

Having an understanding of what you own also plays a vital part in managing a portfolio (and its risk). No better example than Warren Buffet. When he buys a company, he is buying it based on fundamentals. However, even Mr. Buffet has periodically reduced his positions in stocks he has purchased. It could be to invest in other names or just book profits, but even the greatest investor of our time does sell from time to time. His philosophy suggests there are times to buy and times to sell, “Be fearful when others are greedy and greedy when others are fearful.”

For those who are working with financial professionals, I would encourage you to ask them, what is their sell strategy? It could be based on fundamental, economical, or technical reasons, as long as he/she has a plan of action. There are numerous examples of why sticking with a suitable investment thesis can pay off handsomely on the road to building riches, but we are constantly reminded of the bumps we face along the way. It is these bumps that I am trying to reduce so we can have a smoother ride.

Finally, the best investment advice I have heard –

“No one ever went poor booking a profit”.

- Rajiv Hargunani

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Rajiv Hargunani and not necessarily those of RJFS or Raymond James. Rajiv Hargunani, Raymond James Financial Services, Inc., its affiliates, officers, directors or branch offices may in the normal course of business have a position in the securities mentioned in this report. All stock prices are quoted as of 03/02/2011. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Past performance may not be indicative of future results.

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