U.S. financial markets have done very well in recent years. The bull run in the stock market that began in 2009 continued its ascent through 2014.
And U.S. bond prices bucked expectations last year, with the Barclays U.S. Aggregate index, a popular proxy for investment-grade bonds, gaining 6% and the Barclays long-term U.S. Treasury index surging 25%.
Given all these gains, many investors might be wondering if now is a good time to lock in profits by selling some of their holdings. But what factors should influence sell decisions?
To help clarify the issue, we sat down with Steve Greiner, Senior Vice President of Schwab Equity Ratings®, and Kathy Jones, Vice President, Fixed Income Strategist at the Schwab Center for Financial Research, to discuss the elements of creating a sell discipline.
“It’s understandable to think about cashing out because of the strong showing that many of these investments have had,” says Steve. “But it’s critical to make informed decisions, not emotional ones—and to avoid trying to time the market.”
Generally, decisions about which stocks to keep in your portfolio should be informed by an analysis of the fundamentals: What is the financial condition of the company? What is the outlook for the company’s sector or the broader market? Sometimes, technical indicators—such as trend lines and moving averages—might also be helpful.
The following are some signals that might indicate it’s time to sell.
Deteriorating fundamentals. Performance and competitiveness are two important measures of a company’s health. If either is weakening, you may want to consider selling the company’s stock.
Steve says Schwab Equity Ratings—which issues letter grades for thousands of stocks, ranking them from A to F according to a series of fundamental and technical metrics—can help investors determine the relative strength of their holdings.
“We believe your portfolio should be full of stocks rated A or B. If a stock is downgraded to D or F, you might consider selling it,” Steve says.
Portfolio balance. Investors should also consider their overall portfolios when making sell decisions. Has a position increased in value to the point where your asset allocation has strayed from your target? That was the case for many investors in 2013, for instance, when major U.S. stock indexes rose more than 25% and left portfolios overweighted in equities. To remedy an imbalance, you could sell from the stock portion of your portfolio to generate needed cash and buy other asset classes to bring your portfolio back into balance.
Steve says investors also need to make sure their stock holdings are adequately diverse. “I’ve encountered some investors who believed they were well diversified because they had 40 stocks in their accounts,” he says. “Upon closer examination, however, they discovered that two or three stocks represented half or more of their portfolios, or that their portfolios were dominated by stocks in a single industry.”
The bottom line is to set a plan, make sure your portfolio aligns with your risk tolerance and goals, and rebalance as needed. “It’s hard—if not impossible—to time tops and bottoms, so rushing to sell or buy because the market is surging or falling isn’t really a good strategy,” Steve says.
For most bond investors, holding their investments to maturity is usually the best strategy, says Kathy. Barring default, most bonds will deliver a predictable stream of interest payments and a return of principal at maturity.
However, there are a few cases when selling a bond might make sense.
Credit quality change. Kathy says investors should consider selling a bond if there’s a significant or rapid deterioration in credit quality. That said, investors don’t need to wait for a rating downgrade in order to make a judgment about an issuer’s financial health. For example, companies with weak growth prospects that are carrying a lot of debt might struggle to service their obligations, potentially putting them at risk of defaulting.
“Such defaults are fairly rare,” Kathy says. “Still, it’s worth keeping an eye on these investments to make sure their ratings are holding up over the duration of your investment.”
Profit-taking. Investors with bonds that are temporarily trading at a premium to their original purchase price might consider locking in profits by selling. For example, prices of long-duration bonds with high coupon rates tend to rise during periods of persistently low interest rates. That premium will likely disappear as such bonds get closer to maturity, or if rates rise. For investors with such holdings, capturing that premium may make sense—though selling means they will lose the income and may have to pay taxes on capital gains.
“Some investors might want to take the windfall on these bonds and invest in shorter-term bonds, locking in gains and reducing their exposure to the volatility of longer-term bonds,” Kathy says. “Again, unless credit quality deteriorates, most investors are better off holding to maturity.”
So what kind of strategy would make sense for fixed income investors who aren’t comfortable with the potential complications of selling? Kathy says one option would be to consider building a bond ladder—a strategy that staggers the maturities of your fixed income investments—and then create a schedule for reinvesting the proceeds as each bond matures. Ladders don’t protect bond investors from credit or liquidity risks, but they can provide a reliable income stream and opportunities to replenish your holdings as they mature.
*Annamaria Lusardi and Olivia S. Mitchell, “Financial Literacy and Planning: Implications for Retirement Wellbeing,” NBER Working Paper Series, May 2011, page 29.
†The market is represented by total monthly returns of the S&P 500 for January 1926–June 2012.
5 tips for making investment decisions
- Identify your goals. What are you saving for? How do you plan to live in retirement? Knowing the answers to such questions can inform your investing decisions. How soon you anticipate needing your assets will determine how much risk you can take in the market, and whether you need to make short-term moves in or out of investments.
- Make a plan. Investors who plan ahead tend to experience better investing outcomes. In fact, in a study of Americans age 50 and older, “successful planners”—those who were able to stick with their savings plans—were shown to have accumulated three times as much wealth as nonplanners.*
- Update and rebalance. Your needs and circumstances may change. Even well-diversified, well-allocated plans can take on too much risk or lose recovery potential if not periodically rebalanced. Research by the Schwab Center for Financial Research has found that rebalancing your portfolio annually can significantly help reduce its volatility.
- Don’t sit on the sidelines. The risk of pulling out of the market and sitting on the sidelines can be high. The Schwab Center for Financial Research looked at data from Morningstar covering the 16 bear markets since 1926 and found that in the first 12 months following the end of a bear market, a fully invested portfolio performed four times better than one that included a six-month stint on the sidelines before returning to the market.†
- Don’t try to time the market. No one has a crystal ball and timing the market’s tops and bottoms has proven difficult for even the most seasoned investors. The annualized total return of a portfolio invested in the S&P 500 from 1993–2012 was 8.2%. But if you had pulled that portfolio out of the market for just the top 10 trading days, the return would have dropped to 4.5%. If you had excluded the 20 best trading days, the return would have been just 2.1%. Missing by just a little bit can make a big difference.