When to Sell
The Financialist • Issue 90 • October 2006
BY CLAY GILLESPIE
In any portfolio, perhaps the most difficult decision is when to sell an investment.
By definition, every portfolio will have one investment that is lagging in performance at any given time. However, moving from an investment with poor relative short- term performance to an investment with superior short-term performance could yield disastrous results. This "chasing past performance" approach frequently produces below-average results.
Consequently, there are a set of criteria to follow prior to making a sell decision.
Sell Criteria:
CHANGES IN PERSONAL SITUATION
Changes to one’s personal circumstances will require a review of current portfolio holdings to ensure they still match current objectives. As one approaches retirement, for example, portfolio volatility should be reduced. This means selling some of the more aggressive investments and investing in more conservative ones.
REBALANCING YOUR PORTFOLIO
A properly diversified portfolio will require rebalancing from time to time. For example, if one’s personal objectives and risk tolerance suggest an optimal asset allocation of 60% in equity-based investments (common stock, equity funds, etc.) and 40% in fixed income investments (bonds, GICs, etc.), some investments will need to be sold periodically to maintain this allocation.
CHANGES TO AN UNDERLYING INVESTMENT
If an investment fund changes managers, the fund should be re-analyzed to ensure that. The new manager’s style still meets the stated objectives. If this is not the case, the fund should be sold.
The situation becomes more complex when "style drift" is involved. When purchasing an investment fund because of a manager’s particular style, there is the expectation that the style will be adhered to. In today’s marketplace, however, there is great pressure on managers to perform well in any given market; this in turn drives some fund managers to alter their style to match the best-performing strategy in the short-term.
While this may sound like an effective approach, the reality is that "style drift" tends to produce poor performance over time. When a fund manager changes investment styles mid-cycle, the fund may have missed most of the market upside while participating in much of the downside. In addition, when the original style comes back into favor, the fund would miss out on that growth as well.
PEER GROUP ANALYSIS
When comparing investments, it is crucial to compare funds within the same category, i.e. they share the same or similar objectives. For example, comparing the performance of a Canadian equity fund to the performance of a foreign equity fund would be like comparing an apple to an orange.
In addition to comparing the same types of investments to each other, it is equally important to match investments with the same investment styles. Canadian equity growth versus Canadian equity growth or Canadian equity value versus Canadian equity value, for example. To properly assess an investment’s performance, the appropriate comparisons must be used, otherwise the analysis becomes irrelevant.
ADDITIONAL NOTES
In a properly diversified portfolio, the account value will fluctuate with market conditions, but time will typically reduce volatility while increasing the possibility of a positive return. But when analyzing individual securities, it is important to understand that time may not be an ally.
It is common for investors to say "if the investment reaches the level at which I purchased it, I will sell it". The problem is that there is no guarantee any investment will reach the original (or any given value) ever again.
When analyzing an investment, there are a number of important questions to ask:
- "Would I buy it today"? If the answer is no, it would be an appropriate time to sell the security;
- Is a security being purchased on the expectation that it is undervalued?
- Is a security being purchased on the expectation that its earnings (and thus stock price) will increase?
It is important to identify the reasons behind the purchase of any investment, because when these reasons change or cease to exist, it should be sold. An individual security should never be purchased without an accompanying exit strategy in place at the time of purchase.
Achieving long-term success with any investment strategy means developing a disciplined approach to avoid overreacting to short-term market trends. Also, success is dependent on knowing when to sell.