When to Sell a Stock, Mutual Fund or ETF
For most investors, knowing when to sell a stock, mutual fund or exchange-traded fund (ETF) can be one of the most difficult—and one of the most critical—decisions to get right. But how do you know when you should sell? Perhaps more importantly, when should you NOT sell?
In this episode of the Science of Economic Freedom, “When to Sell a Stock, Mutual Fund or ETF,” we discuss the many good reasons to sell along with some of the worst reasons to sell.
Key issues covered in this episode include:
- The differences between selling in a taxable account and a tax-deferred account.
- The reasons why many investors underperform (hint, it has to do with too much selling).
- The biggest reasons NOT to sell, including emotional reactions, market volatility, rumors, politics, etc.
- How to sell for tax optimization.
- When and how to sell when rebalancing your portfolio.
- Why you might need to sell when you are altering your investment strategy and/or when you change advisors.
- How to sell so that your portfolio is in line with your long-term goals.
- Plus, much more.
As anyone who has had to sell a stock, mutual fund or ETF knows, it can be difficult to decide when the time has come for a change. In this podcast, we provide some key principles to keep in mind before you make that critical sell decision.
Doug: When should you sell? What should be your sale criteria? What about tax implications? All this and more on when to sell a stock, mutual fund, or ETF on this episode of The Science of Economic Freedom.
Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.
Doug: Welcome to the Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is all about helping you achieve your financial dreams. We call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones.
Today we want to help you identify your next step on that journey. This is episode 36. When should I sell a stock, mutual fund, or ETF? When should you not sell?
The sell decision can be one of the most difficult and critical decisions for most investors. Today, we want to help you make sense of selling a stock, mutual fund, or ETF. Now, let’s acknowledge that there are traders who make, buy, and sell decisions for a living and there are investors who are more long-term oriented in their thinking. This discussion about when to sell is for investors. Let’s also mention the reasons investors underperform. These reasons are from academic research from a variety of sources. We’ve talked about them here on the podcast before.
This is a good time for review. There is an annual study that has been going on for 23 years from the DALBAR organization. This study, academically based, looks at how investors perform based on their buy and sell decisions in mutual fund shares. Now, the conclusions of this study is average investors underperformed the market significantly. Looking at the most recent study, the average investor over the past 23 years has had a compounded rate of return of 2.3% while the S&P 500 has compounded at about 9%. A huge underperformance.
Why do people underperform
No financial plan
Number one: they don’t have a financial plan. A financial plan puts you in the driver’s seat. A financial plan puts forth projections based on what your assets are, your savings rate is, your goals and objectives. It really helps you determine the kind of asset allocation that you need to have in your investing portfolio. Not taking too much risk, not taking too little risk. That’s the whole reason to have a financial plan. Most investors don’t have a financial plan.
No understanding of risk and risk of loss
Second, people just don’t understand risk and risk of loss. I believe that the best example of this most recently is the Bitcoin phenomena. Last year, Bitcoin was up sensationally some 900%. This year, Bitcoin is down 80%. When did you see the most volume in Bitcoin shares? It was at the market top. That’s when many investors rushed in to get in on this big surge in prices. What happened? Well, when people bought Bitcoin, they didn’t think about the downside. Most investors who bought into Bitcoin earlier this year, have significant losses in their portfolio.
No understanding of the tax consequences
Next, many investors don’t think about or understand the tax consequences. They generate unnecessary tax consequences in their portfolios. They don’t properly diversify. This is another problem for many investors. They take highly concentrated positions in just a few securities. If those securities don’t perform as well as the market, they underperform.
Follow trends from the financial press
Then lastly, individual investors are famous for following the trends that are currently being touted in the financial press.
When should you sell stock?
Now, returning back to our subject of the day. When should you sell? Let’s understand that you have two types of accounts that you manage. You have taxable accounts and tax deferred accounts. When selling an asset in the tax deferred accounts, such as an IRA or a 401(k), there are no tax consequences. When selling an asset in a taxable account, there are most definitely tax consequences. You must understand those consequences before the decision to sell is made.
Now, before we get to the discussion of when to sell, let’s discuss the reasons not to sell. Now, most people are going to be familiar with some of the stories that I’m going to talk about. We have separated these reasons, which are very similar, for discussion purposes. We have seven reasons why not to sell.
Emotional reaction to stock prices
Number one: an emotional reaction to a decline in stock prices. Remember a couple of years ago in August of 2015, we had a phenomena happen in the market that was subsequently dubbed the flash crash. It was a day in August 2015 when the Chinese stock market had a very volatile night. When the futures market opened here in the United States, the Dow Jones Industrial Average, the futures, were down 1,000 points, which at the time, was a very large percentage move, about 5% in the Dow. Many investors who were online traders wanted to get signed onto their accounts early. Some of them put in sell orders before the market even opened. There was a rush of selling in the first hour of trading. That rush of selling actually created some systems problems. Some stocks, ETFs had problems pricing themselves correctly on that day. The fact of the matter is investors rushed to sell at virtually the worst possible time. They did so because of the fact that the market was in a short-term downtrend. We had a capitulation moment with that China news. Subsequently, the market ended up going up from that date. Emotional reactions to market declines are not good reasons to sell.
Extreme volatility in stocks
Second, just extreme volatility in stocks. We had that happen in January of 2018. After a great year in stocks in 2017, the market continued to go up in January. Then we hit an air pocket where stocks corrected 10%. I remember watching the news in the financial news at the time. Once the market had gone down 10%, there were predictions that the decline had just begun. Well, in order for stocks to go down, there has to be an imbalance between buy orders and sell orders. Many people were selling. They were selling because stocks were volatile. We also went through another volatile period here in October of 2018, where stocks again corrected 9, 10%. These are not good periods of time to be selling stocks just because they’re volatile.
Number three: news headlines. Do you remember back in 2011 when the United States had a debt downgrade because of problems with Congress and not raising of the debt ceiling? During that debt crisis, US stocks corrected almost 20%. Small cap stocks actually went down more than 20%. Many investors were selling because of the news of the debt downgrade and things were going to get worse. Of course, Congress resolved that issue. That was actually the low in the market for the next three years. Not a good time to sell when you’re seeing headlines.
Asset class is underperforming
Reason number four: an asset class is underperforming. Now, let me talk about asset classes for a second. There are different classes of stocks. You have small cap stocks, value stocks, international stocks. Within these classes of stocks, you go through periods of underperformance and outperformance. Well, our factor investing model actually compensates for this and identifies those factors that we want to be invested in following the Mercer Advisor’s strategies. There are times where you go through periods when a certain segment of your portfolio is underperforming. In this current period of time right now, international stocks are underperforming. Does that mean you should not have international stocks in your portfolio? Absolutely not. International stocks perform just as well as US stocks over the long term. We go through periods of underperformance. I’m sure some time in the future we’re going to go through a period of underperformance with US stocks. You don’t want to sell because a certain class of stocks that fit into your portfolio are underperforming for a period of time.
You don’t want to sell because of what you have heard
Number five: you don’t want to sell because of what you have heard. I heard the market is going to crash. I’m selling in May and going away. There are many predictions on what’s going to happen next in the market. It’s what sells newspapers and creates clicks on websites. These are not reasons to sell.
Everybody else is selling
Number six: everybody is selling so I should too. When somebody has sold out of the market and you happen to have had a conversation with this person, they’re going to be pushing their point of view. They’re going to be telling you that you should get out because they’re out. They’re going to give you all the reasons why the stock market is going down. That is not a good reason to sell.
Lastly, politics. I don’t like Bush, Obama, Trump, a red Congress, a blue Congress. Pick your most hated politician and come up with a point of view. That is not a reason to sell.
When to sell?
Now, let’s get to a discussion about when to sell. There are 10 reasons we came up with to make the decision to move on from an investment holding. Again, I want to stress that you must consider the tax consequences of a sell decision. In addition, you should have the appropriate data to back up your decision. Finally, we also suggest that you get a second opinion on the sell decision. That second opinion could come from a trusted advisor. This could be your spouse, your CPA, a financial advisor, a friend, a relative. Someone who has some understanding of finance and you could run your logic by that person. Now, you should never make the sell decision in a short period of time. You want to methodically go through things. Here are our 10 reasons to sell.
Raise cash for a distribution, cash flow, or a major purchase
Number one: raise cash for a distribution, cash flow, or a major purchase. We sell positions all the time for clients that are fully invested and that need a cash distribution. Maybe we only sell once a year, maybe we sell quarterly but we have a client’s portfolio fully invested. They need to take a required minimum distribution, or the client calls up and says, “Hey, I need $10,000 out of my account.” That is a reason to sell. There’s nothing wrong with that. It is your money. You get to make these decisions. What you’re going to sell, you should give some thought to. The way we go through this is we go back to the asset allocation of the client, look at their current allocation based on what’s happened in the market in the last six or twelve months, and we sell positions to bring the client back online with their long-term allocation.
Reason number two: tax optimization. This is one of the best reasons to sell. As I asked my colleagues about this podcast content, this was the first to be mentioned by several advisors. Selling a position that is at a loss and possibly matching a corresponding gain so you can reallocate those assets is a good reason to sell. You’re taking advantage of the tax code and you’re going to have cash to be able to reallocate in your portfolio. Tax optimization is important.
Now, one of the things that happens with people is that they don’t end up really thinking through their buy and sell decisions over time. Sometimes, they end up with a very large tax loss carryforward. I was looking at a client’s account recently and came across the fact that they had a $600,000 tax loss carryforward. Well, it’s difficult to create $600,000 of gains but that is what we were seeking to do with their portfolio because they had this big tax loss carry-forward. Understanding your tax consequences. Understanding the tax consequences of a sell decision is critical.
There’s a low-cost vehicle that has the same investment strategy
Reason to sell number three: there’s a low-cost vehicle that has the same investment strategy. There are still many expensive investment products on the market today. Case in point, I did a search as I was preparing for this podcast. I looked for the most expensive S&P 500 index fund. Now, this particular index fund is offered by a major insurance company with a 5% sales charge and an annual expense ratio of .64%. You can get the same product for .04%. That’s a discount of almost 90% in cost. That is a good reason to sell. When you can lower the expenses of your portfolio by 90% and not pay a 5% sales charge.
Your mutual fund has consistently underperformed its benchmark over multiple horizons
Reason number four: my mutual fund has consistently underperformed its benchmark over multiple time horizons. This sell decision requires research. Mutual funds, especially actively manage mutual funds, can and do go through periods of underperformance. You want to make sure that you have the appropriate benchmark for measuring that mutual fund’s performance. The S&P 500 might not be the appropriate benchmark. If you’re in a value fund or in a small cap fund, the S&P 500 is not the appropriate benchmark. You want to make sure you’re looking at long-term time horizons. Five years or more. If your fund has been consistently underperforming for five years and you’re paying extra management fees for that active management, that’s an indication that you want to look elsewhere. You want to do the research and you want to back it up scientifically. You want to back it up with evidence.
Reason number five to make the sell decision: rebalancing. Now, rebalancing should be done quarterly and systematically. What we mean by systematically is if you have different positions in your portfolio and one particular portion of your portfolio has gone up significantly. This happened most recently in Mercer Advisors’ portfolio with momentum stocks. Momentum stocks did very well in 2017. The momentum allocation in our portfolios was way ahead of other allocations. When you look back at your quarterly allocation, you want to sell down some momentum portion. It might only be 2 or 3% of the portfolio or 2 or 3% of the position but that’s how you rebalance. If bonds had been underperforming and you have a 40% allocation to bonds, at the end of a quarter, you might buy more bonds even though they had been underperforming to get yourself back in balance. Rebalancing and having a balanced portfolio is a good reason to sell.
Your time horizon has changed
Number six: your time horizon has changed. You’re going into a new phase of your life. Many times, people have a high equity allocation when they’re younger. When you’re within three, four, five years of retirement and you’re 100% allocated to the stock market, maybe that’s a time to discuss with your advisor backing off. It might make sense to move from 100% equity allocation to a 70/30 allocation between stocks and bonds because your time horizon is changing. Your goals are changing. You’re no longer in accumulation mode. You’re going to be moving into distribution mode.
You have a highly concentrated position in your portfolio
Reason number seven: you have a highly concentrated position in your portfolio. This is a position that represents more than 5% and this can happen with a stock, mutual fund, or ETF. Most of the time, it happens with individual stocks. You got lucky. You had a stock that just went up significantly more than the market. Highly concentrated positions are risky positions. You can reduce risk. There are many ways to reduce risk. We did a podcast recently on highly concentrated positions on how to reduce risk. You need to have a plan.
You inherited an asset or your current portfolio does not fit your updated financial plans
Reason number eight to sell: you inherited an asset, or your current portfolio does not fit your updated financial plans. Individual stocks to mutual funds or ETFs could be an example of an asset that doesn’t fit your new plans. We’ve had clients come on board that have had high concentrations in particular sectors of the market. It could be energy or it could be healthcare because they’re from those industries. That could be a reason to sell that you’ve got too much concentration in a particular type of stock and you want to get yourself more balanced.
Your goals have changed
Reason number nine: your goals have changed, you sold a business, or you sold some real estate assets. Maybe you want to downshift your risk or even upshift. Now, upshift would require buying stocks, but I’m bringing up the point that people’s goals change sometimes. There’s nothing wrong with that. This is your money.
You have changed investment advisors
Then reason number 10 to sell a stock, mutual fund, or ETF is you have changed investment advisors. Sometimes it makes sense to move from one investment strategy to another. Maybe one of the reasons why you hired a new investment manager is because you liked their investment strategy better than the previous advisor’s investment strategy. Now, a competent investment advisor is going to do a deep tax analysis before they move you from one portfolio to another, so you have as few or as little tax consequences as possible. This is another reason to sell.
Get a second opinion
As I mentioned earlier, getting a second opinion on sell decisions is a good practice. Never make a sell decision in a vacuum and always have some data when you’re going to make a sell decision. One of the most important parts if you’re managing your own portfolio or if you’re overseeing the management of your portfolio by an investment advisor is you want to have conversations. If they’re deciding to sell something in the portfolio, let’s have a conversation as to why and ask for the data. These are just good practices.
Now, let’s talk about some action steps from today’s podcast. Number one: study your IRA and 401(k) positions first. What is the cost of your holdings? How are they performing against their peer groups and other options? Is there anything in your retirement accounts that is not performing to your expectation? Again, it could be that it’s just an asset class that’s underperforming but it could be that there is an investment that is underperforming. Remember in your IRA and 401(k), you have no tax consequences to the move.
Second, look at your taxable accounts and begin with a look at your cost basis. Your cost basis is the price that you paid for that particular security. Then review it through the lens of your asset allocation and your current goals. Do you have the equity allocation that you want to have? Do you have too much cash in your portfolio? Is there anything that you own that is not aligned with your investment goals? These are the critical questions that you need to ask yourself.
Then lastly, I’d love your feedback on this podcast. Maybe you’ve got some questions about the sell decision content that we discussed here today. I will remind you that you can send me an email. My email address is [email protected] [email protected] This is Doug Fabian. Thanks for listening to The Science of Economic Freedom.
Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors, Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors, Inc. is the parent company of Mercer Global Advisors, Inc., and is not involved with investment services.