|Contributed by: martingale |
When should you sell a stock? The answer may surprise you.
If you browse the investment literature you are sure to find a lot of advice on when to sell. The news wires buzz with analysts recommendations to buy, hold, or sell an investment, or to underweight or overweight it. Or you'll hear that you should periodically rebalance your portfolio--exchanging growth stocks for values, or blue chips for bonds when the market is up or down, or depending on where interest rates are said to be going, or how confident the Canadian or American consumer is said to feel this month.
Is there any merit in the common sense advice to buy low and sell high? How do you know when it's high anyway? And who knows where interest rates are going to go?
The investment industry loves it when you trade. Traders and market makers earn a living on the difference between the buying and selling price (the spread); meanwhile your broker will earn a nice commission on your trade. Even at a low-fee discount broker it'll cost you $25 in fees just to sell. The more you trade your securities the richer your broker will be. But what about you? When is it in your interest to sell?
Clearly you will have to sell some day--when you're old and you need the money you'll have to sell off your position little by little in order to generate a living. But how about before that? Surely a company that was a good investment back in 1990 might be ripe for the picking now? Aren't there other, better stocks you could be invested in?
Let's say you pumped some money into Nortel in the 1990's when prospects seemed better. You've since seen your $5000 investment drop in value to $500. Isn't it time to pull that money out, and invest it in a better company? Definately not! At $500 your Nortel investment is fairly valued. If it were really worth only $250 everyone would sell immediately, and within minutes the valuation would drop to $250. If it were worth even one nickel more per share then the resulting buying frenzy would soon drive the price up by that nickel.
The reality of an efficient market is that every stock on the market is fairly priced. Nortel's value dropped because of new information. You paid a fair price when you bought it, given everything that was known about Nortel at the time. As the future unfolded with typical surprise new information came along, and that caused a re-evaluation of the company. Today your Nortel stock is trading at a price that is fair, given everything we now know. Yes, you've lost money--but now you're holding it at a fair price.
Were you to sell your $500 investment now you would incur a trading cost--you'd pay the difference between the bid/ask spread, and you would pay a commission to your broker. You'd then pay another round of commissions to re-invest that money into something else. You'll get a fair price for that new investment--just like you'll get a fair price for everything that trades on the market. In exchange for two rounds of trading fees you managed to exchange one fairly valued security for another. Your $500 was still reasonably invested and now you've got $450 reasonably invested in some other company. The only material difference is that you're $50 poorer and your broker is $50 richer.
When should you sell? Never; or not until you have to. Put your money in, and leave it there until you want it back. Perhaps you'll sell because you want to send your daughter to University, or because you've retired and you need the cash for your daily life. That's great. But don't sell because you think some different investment would be better.
There is merit in the argument that you should rebalance every now and then, but not because of what the market does--ignore the market. Nobody knows what will happen next! You might, though, want to rebalance every now and then depending on what happens to you.
For example, you might have invested in high-risk growth stocks in the past because you were young and had years of income ahead of you. You could afford a few setbacks along the way, so you took some risks. But now your daughter is celebrating her twelfth birthday, and you're thinking that in five or six years she's going to be all grown up and going to University. In particular, you're thinking, "damn, that will be expensive!" That thought might prompt you to begin a gradual rebalancing--slowly exchanging some of your more risky investments for something safer so as to ensure you'll have the money she'll require when the time comes. Similarly, as retirement approaches it is sound thinking to gradually switch to lower risk securities, for the same reason.
The key word here is gradually. Big life events like buying a house, retiring, or sending your daughter to school can be planned years in advance. There is never any reason to rush out and sell all your investments at once. Ideally, you can just put all new money into safer investments and rebalance without having to sell at all.
You may wonder whether our markets are truly efficient--is every stock really trading at the fairest price? There definately are some anomolies in our markets--inefficiencies which can be exploited, where a security is trading just slightly off the fairest possible price. Were you to spend an enormous amount of time and money arbitraging one of these inefficiencies you might be able to earn back marginally more than you spent on trading fees. Maybe. But one thing is for sure: the more you try an do that, the richer your broker is going to get. Other articles in this series will explore just how efficient our stock markets really are.
In the meantime, you can earn an excellent return for free (no fees!), and with zero effort on your part. Just leave well enough alone. Go out and live your life happily, comfortable in the knowledge that every penny you have invested in the market is working for you efficiently.