Investment Consult

April 24, 2000

Hanging on too long? Selling too soon? These tips could improve your judgment.

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When to unload a stock or fund

Hanging on too long? Selling too soon? These tips could improve your judgment.

By Lewis J. Altfest, PhD, CFA, CFP

The way some people brag about their investments, you'd think everything they own produces double-digit gains every year. They'd retire tomorrow if their jobs weren't so darned interesting.

Don't let 'em fool you. I don't know a single person who hasn't had losing investments. And it's not just that they buy the wrong things. Often, they don't know when to sell what they've bought. Some people can't face having made a mistake, so they hold a loser too long, hoping the investment will bounce back. Others can't resist the possibility of more profits, so they hang on long enough to see their gains evaporate. Still others decide to grab profits too soon. Just ask the great Warren Buffett, one of the shrewdest investors of our day, who unloaded millions of shares of McDonald's before the company's strong showing in 1998.

So when is the right time to sell? Here are some guidelines.

Let's talk about stocks first. In general, you shouldn't take a drop in price as an absolute sell signal. For example, a client recently asked me to dump a stock that had fallen from 18 to 12. That's a significant loss, but the stock had a price-earnings ratio of 7. The average ratio of companies in the Standard & Poor's 500 Stock Index is 32, so that stock's comparatively low P-E indicated to me that it might be severely undervalued at 12. After examining the company's most recent financial statements, I concluded that the setback was probably temporary. I encouraged the client to buy more shares, while they were selling at what I perceived to be a discount. Will she be rewarded? The numbers suggest that she will, but it could take six to 12 months before we find out. If after a year, the earnings don't improve, we may well pull the plug on it.

Never sell a slumping stock until you find out the whole story behind its decline. For instance, despite a strong balance sheet, Intel fell short of Wall Street's expectations in 1997, and its stock stumbled. However, this wasn't a sign to sell. Intel underperformed not because of any significant problem with the company, but because turmoil in Asian markets temporarily reduced demand for its Pentium chips. In addition, Intel had spent a lot to develop and package its Pentium II processor, which reduced its margins. Anyone who sold missed out on a great 1998, when the stock soared 92 percent. Conversely, when Apple Computer steadily lost market share to IBM and other PC makers during the 1980s, it was a strong signal to sell Apple stock. Apple didn't recover until years later.

Many investors have trouble differentiating between a company's short-term setbacks and those likely to alter its fundamental prospects. "Tips" posted in an Internet chat room or on an electronic bulletin board often add to their confusion. Many such tidbits are false or misleading, designed to line the pockets of the people who circulate them. (See "Online investment scams: Coming to a screen near you," April 10, 2000, available at www.memag.com).To get the straight scoop, stick to analysis, charts, and statistics from reliable sources such as Bloomberg, Dow Jones, Morningstar, and Value Line.

The same trusted sources that help you decide when to sell a poorly performing stock can alert you to a high-flier that could lose altitude. For instance, after the buzz on Internet stocks died down and people began focusing on the fundamentals, especially earnings, the prices of many of these companies dropped precipitously.

Naturally, I always look at the financial statements. But I also routinely examine the "insider selling" numbers in Value Line, because an unusual amount of selling by the big shots may indicate that trouble is afoot. Likewise, I watch the P-E ratio of any media-darling stock, because a rising P-E—especially one that's much higher than those of the company's peers—may mean the stock could become overvalued, if it hasn't already.

Any number of other factors—stronger competition, shortages of raw materials, rising labor costs, overseas turmoil—can cause a winning stock to level off or languish. By staying informed in as many ways as possible, you'll increase the odds that you'll sell at the right time.

What about mutual funds? With them, you should focus on performance numbers, because it would be too time-consuming to analyze the fundamentals of every stock in the portfolio. Consider dropping any funds that finish in the bottom quartile of their peer group for a year—two years at the most. But note the key words here: peer group. For a large-cap growth fund, for example, that means comparing its relative risk-adjusted performance with that of other large-cap growth funds. Measure a small-cap value fund against other small-cap value funds.

You'll find this basic information in the hard-copy version of Morningstar, but if you own the company's Principia Pro CD-ROM program, you can make more intricate comparisons. For instance, you can examine funds that are not only the same type but also have roughly the same amount of money under management.

Even if your fund is doing well, watch for a signal to sell. In fact, a fund's success can foster such signals. For example, a big influx of money usually follows a stellar year. More cash can present problems, because the manager may have trouble finding enough good companies to invest all that money in. This can be particularly troublesome for small-cap funds.

Furthermore, a fund's success might mean that it now occupies a big enough position in your portfolio to throw your asset allocation out of whack. In that case, you might want to sell some shares to improve the balance. Also think about reducing your holdings in a fund whose highly successful manager leaves the company or is assigned to another of its funds.

Finally, consider selling a fund whose focus or philosophy has changed so that it's no longer in line with your investment goals.

What you shouldn't do in deciding whether to sell a mutual fund—or an individual stock, for that matter—is compare its performance against the broad market. (Index funds designed to track the overall market are the exception.) One of my clients, a gastroenterologist, was misguided in this respect. At the end of the year, he wanted to get rid of everything that had underperformed the S&P 500, whether it was a small-cap mutual fund or an international stock that had suffered because of currency devaluation that was likely to prove temporary. If left to his devices, this doctor would have decimated his portfolio and upset the asset allocation plan we'd carefully created for him. I explained to him that just because one market sector is hot today doesn't mean it will be tomorrow, and that's why it's important to diversify. After we reviewed the principles I've laid out in this column, he came to a better understanding of when it's truly time to throw in the towel on an investment.

 

The author, a fee-only financial planner, is president of L.J. Altfest & Co. (www.altfest.com), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult. Medical Economics 2000;8:50.

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