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Financial Decoder Bonus: If You Have to Sell, How Do You Choose?

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If You Have to Sell, How Do You Choose?

No one likes to sell when the market is down, but some investors don’t have a choice. In that case, what’s the best approach?

On Financial Decoder, we often emphasize the importance of taking a long-term approach to investing, but not everyone has that luxury. Some investors have bills to pay right now and need to pull money from their portfolios to make those payments. In this bonus episode, Mark Riepe discusses several approaches for selling smartly if and when you have to.

 

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MARK RIEPE: From February 19th to 28th the U.S. stock market experienced its fastest ever correction[1] thanks to the growing pandemic of the coronavirus, or COVID-19, and its potential impact on the global economy. A “correction” is when the U.S. stock market drops by at least 10% from its peak value, but it hasn’t dropped so far as to become a bear market.

Naturally, investors worry during times like these—and wonder how the market movement should impact their decision-making.

At Schwab, we’re strong believers in taking a long-term approach to investing, but not everyone has that luxury. Some investors have bills to pay right now and need to pull money from their portfolios to make those payments.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. This  special bonus episode is about how to decide what to sell when you absolutely have to sell.

No one likes to sell when the market is down, but sometimes you don’t have a choice—maybe you have to pay your taxes or a medical bill, or you’re retired and need to replenish your cash reserves. How can you make the best of a bad situation?

The most important thing is to think strategically, and not just liquidate assets as part of a mad rush to the exits.

That’s hard to do because having to make a sell decision is already fraught with biases, and those are magnified when the decision must be made in the throes of market upheaval.

Way back in episode 2 of season 1 we talked about how investors are far more likely to sell positions that have appreciated in price since they were purchased, than those that have declined.

This is loss aversion at work. By that we mean people are reluctant to realize losses and will try to avoid locking in a loss—even when hanging on isn’t the best choice.

But when markets drop quickly and everything seems to be moving in the same direction, then herding comes into play—and investors may be overeager to sell indiscriminately. Recency bias can also be a factor, because it’s easy to imagine the downward trend continuing.

If you’d like to learn more about these common biases listen to the episode titled “Which Biases Should You Protect Against?”

So, how can you guard against these biases when you absolutely have to sell? You need a rational approach that doesn’t undermine your ability to meet your investing goals. In the best-case scenario, this can be an opportunity to actually improve the quality of your portfolio.

Here’s a four-step process for how cash-strapped investors should proceed.

The first step is to rebalance your portfolio.

Rebalancing refers to the process of periodically selling overweight positions and buying underweight ones.

This is done to keep your portfolio in line with your chosen asset allocation and risk level—and is a good practice in the best of times.

It can also help you be methodical if you need to generate cash when times are tough. That’s a mouthful of jargon so here’s an example.

Imagine you’re an investor with a moderate tolerance for risk and a target allocation that is 60% stocks, 35% bonds and 5% cash investments.

Let’s further imagine that as stocks appreciated over the course of the long bull market, your stock allocation gradually drifted from 60% to 80% of your portfolio.

Selling some of your stock holdings to bring you back to your 60% target allocation is a good idea for many reasons.

First of all, it helps you generate cash to pay your bills. Plus, you can use what’s left over to invest in your underweighted asset classes. This gets your portfolio’s risk level back to where it should have been in the first place.

The second step is to take out the garbage. Rebalancing gives you an opportunity to revisit all of your holdings to see if they still deserve a place in your portfolio. In other words, rebalancing tells you to sell stocks, in our example, but it doesn’t tell you which stocks to sell.

Look through all of your holdings. If you wouldn’t consider investing more in a particular security, then you should seriously contemplate selling it.

Don’t be sentimental: However attractive a stock looked or performed in the past doesn’t matter if it’s unlikely to deliver for you in the future.

If you’re a Schwab client, you can get a sense of a stock’s prospects by logging into schwab.com/research and entering its ticker symbol.

Mutual fund investors can also see how their holdings compare by entering a fund’s ticker symbol and taking advantage of our mutual fund analysis tools.

But what if you go through this exercise and determine that all your securities are of reasonably high quality? Then you’re on to step number three.

The third step is to harvest losses. If you’re holding an investment with an unrealized loss in a taxable account, consider selling it. This will allow you to both raise cash now and use that loss later to offset either investment gains or ordinary income.

In fact, you can offset up to $3,000 of your ordinary income per year until all your losses have been used up.

This is a strategy known as tax-loss harvesting.

Just be sure you don’t violate the wash-sale rule by repurchasing the same or “substantially identical” securities within 30 days before or after the sale, lest your losses be disallowed. 

The final step is to sell in a tax-smart way. If you still need to sell assets, focus on those you’ve held for more than a year to take advantage of lower long-term capital gains tax rates.

Gains on stocks, bonds, and mutual funds held for over one year are currently taxed at a maximum federal long-term capital gains tax rate of 20%. Investments you’ve held for one year or less will be taxed at your federal income tax rate, which is higher for most investors.

Selling when the market is down can be painful. However, it can also serve as a wake-up call to revisit your plans—or to create a plan if you don’t already have one. Your first line of defense against market volatility should be a portfolio that is appropriately allocated based on your goals, investing timeline, and the amount of risk with which you’re comfortable.

People near or in retirement should think about dividing their money into three buckets. The first bucket is for money to be spent in the next year. The second bucket is for money to be spent two to four years from now. The final bucket is for money to be spent beyond four years from now. These buckets should contain an appropriate combination of higher and lower risk investments. Bucket one is especially important. Make sure you have it invested conservatively because the money in that bucket is money you plan to spend over the next year. Investors with a reserve react a lot differently than those who get blindsided and have never laid that groundwork.

Finally, it’s not just about your risk tolerance, which is your ability to emotionally handle big price swings and losses. It’s also  about your financial capacity to handle risk. In other words, can you afford to take a loss?

Thanks for listening to this special episode. We hope it helped you think strategically about selling—if you have to. Whatever the case, it’s always wise to remember the value of maintaining a diversified portfolio and staying focused on your plan. 

For our latest advice on navigating the ups and downs of the markets, check out schwab.com/volatility.

If you have questions about what to do with your portfolio, you can always call Schwab at 877-279-4476.

If you’ve enjoyed this episode, consider leaving us a rating or review on Apple Podcasts or your favorite listening app.

For important disclosures, see the show notes and schwab.com/FinancialDecoder.

 

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

Investing involves risk including loss of principal.

Apple Podcasts and the Apple logo are trademarks of Apple Inc., registered in the U.S. and other countries.

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