Buy, sell or hold? These are the eternal questions investors everywhere face. Of the three, investors seem to struggle most with the decision to sell. Let's take a close look at two fundamental reasons for selling a security.
1. YOU NEED CASH
Most of us know it's a good idea to keep sufficient cash reserves for unexpected expenses and only commit long-term investment money to volatile markets.
Ultimately, however, your portfolio is a tool that you likely mean to use someday. Chances are, you eventually will sell some stocks to one degree or another in order to fund various long-term goals, ideally as part of a thoughtful distribution scheme that combines cash-flow planning with portfolio rebalancing. Enjoying the fruits of a prudent long-term investment plan is what it's all about.
It's important to recognize the difference between unexpectedly having to raise cash in a forced sale at the worst possible time and the strategic use of your portfolio over an appropriate, predetermined time frame. Given the latter, selling to raise cash can be a legitimate, prudent motivation. In this case, seeking an appropriate investment alternative is not a factor.
2. YOU HAVE AN ALTERNATIVE, POTENTIALLY BETTER INVESTMENT
If you sell a security but don't plan to spend the proceeds, the logical choice is to switch to a potentially better investment. This category is something of a catchall, and could include any of the following:
*Portfolio rebalancing. If your portfolio asset allocation is out of balance — with stocks overweight to your normal allocation, for example — you might sell some stocks in order to purchase bonds to get back into balance (or the other way around, if the bond portion becomes overweighted). Here, the "better alternative investment" is dictated by your overall portfolio investment policy.
*Concentrated position. Similar to rebalancing your portfolio by broad asset class, you may find that you're over-concentrated in a specific stock, industry or sector. If you choose to sell down to a prudent level and redeploy the proceeds, you'll need to find an alternative, more suitable investment.
*Price target reached. Many investors set predetermined price targets, either to the upside or downside, at which point they'll sell a particular security. If you aren't spending the money, then the logical assumption is that you'll reinvest the proceeds.
For some, temporarily parking the proceeds in cash (as an asset class, not for near-term spending) might represent a better alternative, despite the potential pitfalls and perils of attempting to time the market. However, if you have a long-term target allocation you wish to stick to, you'll eventually need to find an alternative investment.
*Fundamental change. Irrespective of price targets or time horizons, a security may undergo significant, fundamental changes that you couldn't foresee when you bought it. For example, news about a company or industry could lead you to sell a particular stock or bond. Likewise, news about a mutual fund — such as a change in manager, investment philosophy or long-term performance — could impact your decision to sell.
A good question to ask in the face of changing fundamentals is, "Would I still buy this security today based on what I know now?" Again, assuming you decide to sell but intend to maintain your overall asset allocation, you have to find a suitable home for the proceeds.
REASONS NOT TO SELL
The key word in this discussion is "reason." Try to avoid acting on emotion — for example, buying out of greed when times are good or selling out of fear when times are bad.
Resist the temptation to think you can consistently outsmart the market. Focus on an asset allocation suited to your long-term goals and have a reason for every decision to sell or buy. Think your decision through to its logical conclusion: Have you reached your goals and need the cash? Or, do you have an alternative, potentially better investment in mind? Does your decision have nothing to do with emotion? If so, then go ahead and sell.
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