How to Make Rational Buy and Sell Decisions

If you're willing to buy or sell an asset at any price, that's probably a tipoff that you're not thinking rationally. To add more discipline to your investment decisions, study a stock's fundamentals—including the price-to-earnings ratio, dividends and buybacks, and return on capital—and consider those data points in the larger context.

• Favor stocks of companies with high levels of cash and low levels of debt, both of which suggest good financial health.
• Be wary of stocks of companies whose earnings growth seems excessively high, because they're likely unsustainable. Conversely, you should also be skeptical if a company has no earnings at all, especially if it's in an industry that investors are piling into. A company with no earnings might be living on borrowed capital.

• Watch for deteriorating fundamentals, which often indicate trouble. It's reasonable to consider closing out a position as soon as it fails to live up to your original reasons for buying it. But if the stock's price falls while the company's fundamentals remain strong, the stock could be well-positioned for a rebound. In that case, don't let fear trick you into parting ways with a worthwhile investment.

Beyond fundamentals, it's also a good idea to pay attention to investor sentiment about a particular stock. Following the herd isn't a sound investment strategy, but that doesn't mean you should ignore sentiment entirely. If investors are starting to sour on a stock, you should question why, since sentiment is often a leading indicator of price decline.

Because bonds are relatively stable, investors are less likely to dump them in a fit of panic selling. On the contrary, bond investors should be wary of panic buying. For instance:

• Don't buy bonds that upend your target asset mix: Having some exposure to Treasuries makes sense for many investors because bonds are a vital part of a well-balanced portfolio. But think carefully about the appropriate allocation. Don't rush into Treasuries in response to a weakened economy. Remember, time in the market generally beats trying to time the market. During a market downturn, investing heavily in bonds might offer more portfolio stability, but it could throw your long-term financial goals off track.
• Don't buy risky bonds just to boost yields: Even with 10-year US Treasury notes yielding close to 4.4%, you may be tempted by higher-yielding alternatives. And yields in the riskier parts of the bond market are higher—for example, high-yield corporate bonds are currently at 7.5%.¹ But high-yield bonds come with greater risks, and letting the search for more yield dictate your investment strategy is exactly the type of emotional decision-making you want to avoid. Those high-yield bonds bring a much higher default risk than their investment-grade counterparts, and investors have to decide if they are being fairly compensated for those increased risks. Some investors might consider high-yield bonds in moderation, but we wouldn't suggest a large allocation.

That said, if you can tolerate a bit more risk while still adhering to your long-term strategy, investing in high-yield bonds through an exchange-traded fund (ETF) or a mutual fund can help mitigate default risk. Diversification is paramount when investing in high-yield bonds. If you're holding just a handful of individual issues, even one default can have an outsize effect on your portfolio. Owning them in a fund—which typically owns hundreds of bonds—can mitigate that risk.

What if the choice is not about buying but selling? When should you consider selling a bond? One good reason would be if an issuer's credit quality has deteriorated to the point where you just aren't comfortable with the additional risk. Another would be if you simply need the cash. In either case, don't let closing out a position throw off your target allocation to bonds—you should still aim to keep your portfolio balanced and in line with your overall goals.

It can be tempting to get into or out of ETFs and mutual funds whenever a big market swing occurs. Unless you're an active trader, however, you should avoid basing your investment decisions on market trends.

Most investors know that trying to time the market is contrary to achieving their long-term goals; but knowing that to be true doesn't necessarily keep you from making emotional decisions when markets are surging or slumping.

To help keep a level head, base your buy and sell decisions on quantifiable factors, such as:

• Fees. When adding funds to your portfolio, generally favor those with lower operating expense ratios—every dollar you pay in fees is one you can't invest for future growth. That's an easy rule to follow with index funds, whose fees tend to be relatively low, but it's not so cut-and-dried where actively managed funds are concerned. Paying a higher fee for an actively managed fund could make sense if you believe the fund will deliver superior returns. But don't base such decisions on past performance, because strong returns could be due to luck and might not persist. The same holds true for those you already own. If any of your current funds seem overly expensive relative to comparable alternatives, it might be time to make a switch.
• Investment strategy. Whether you're looking for broad exposure to the market or access to a specific sector or industry, always confirm that a fund's investment strategy is in line with your expectations. Two funds that seem similar on the surface could take very different approaches with their investments. Likewise, it's a good idea to check in on your current funds' strategies periodically—especially your active funds. Managers may adjust their strategies from time to time in an effort to boost returns or respond to the current environment. If this happens with any of your holdings, make sure you're comfortable with any changes in direction.

When your emotions are running hot, they can steer you in the wrong direction; slowing down and focusing on the facts can help you make the right decisions at the right time and for the right reasons. That may sound obvious, but it's harder than you might think—especially in the heat of the moment.