We all know the refrain — don’t chase performance.

Financial advisers have long extolled the virtues of maintaining a diversified portfolio during times of rally and recession. By staying the course, they insist, average investors are far less likely to make the mistake of buying stocks too late, selling too soon or undercutting gains with costly commission fees.

Countless studies bear that theory out.

Most recently, Boston-based financial research firm Dalbar’s 2009 Quantitative Analysis of Investor Behavior shows that over the past 20 years, ending December 2008, the Standard & Poor’s 500 returned an average 8.35 percent per year. Meanwhile the average equity fund investor earned just 1.87 percent annually — far less than the rate of inflation.

It found that market declines during that period, including the most recent downturn, fueled widespread panic among investors, prompting them to sell at the worst possible times and exacerbate losses.

“It is undeniably true that investors generally don’t know when to sell,” says Dalbar’s President Lou Harvey. “As market conditions change, people’s risk tolerances change as well, so the effect is that when the market goes down they become highly risk averse and move to more secure investments.”

Create an exit strategy
  • Consider taxes.
  • Look at P/E ratio.
  • Focus on cash flow.
  • Beware the outliers.
  • Check new management.
  • Sleep easy.
  • Stick to a system.

While the buy-and-hold strategy of purchasing quality stocks and riding out the short-term storms helps investors avoid such mistakes, that too creates confusion over when, if ever, to dump a dog.

After all, not all stocks bounce back, as the market collapse has made painfully clear. (Think Washington Mutual.) Lacking direction on when to get out, too many investors go down with the ship.

According to Harvey, today’s turbulent market makes it all the more critical that investors create an exit strategy for the stocks and funds they own, one based on fundamentals rather than gut reaction.

Part of the reason investors find it tough to sell an underperforming stock, of course, is that they fear it might recover the minute they bail. On some level, it’s also hard to admit defeat.

Current market conditions, in which most stocks are trading well below their one-time highs, make pulling the trigger harder still.

So how do you know when it’s time to cut your losses and run?

Consider taxes

It may make sense to dump a bad stock if you can use the loss to offset capital gains, says Mark Luscombe, a principal analyst with CCH, a tax and accounting group in Riverwoods, Ill.

If your capital losses exceed your capital gains, the excess can be deducted against your ordinary income up to $3,000 or your total net loss for the year — whichever is less.

If your capital loss is more than the yearly limit, you can carry over the unused portion to future years — up to $3,000 annually — and treat it as if you incurred it in that year.

Luscombe is quick to note, however, that tax implications should never dictate investment decisions.

“Don’t let the tax tail wag the investment dog,” he says. “Investment decisions should ultimately control whether you buy or sell. At least wait until the end of the year when you know pretty well what your situation is in terms of gains or losses, and then you can start weighing the tax implications.”

Be mindful, too, of the wash-sale rule, which prevents investors from artificially generating a loss for tax purposes by selling a stock and then buying it back within 30 days.

Look at price-earnings ratio

It also makes sense to evaluate each stock’s performance rather than using a generic stop-loss system to sell if it falls below, say, 20 percent of your purchase price, says Paul Larson, equity strategist for Chicago-based mutual fund tracker Morningstar.

The readily available price-earnings, or P/E, ratio, the price of a company’s share price divided by its earnings per share, is a good first step.

A stock’s P/E ratio, often called its multiple, measures the level of confidence investors have in a company. The higher the quality of the company, based on profitability, growth rate and competitive advantage, the higher the ratio.

If a company’s P/E ratio is 15, it means investors are willing to pay $15 for every $1 of earnings a company generates.

A company’s multiple can be easily found on financial Web sites offering stock quotes, including Yahoo! Finance and Morningstar.com.

Historically, a reasonable ratio is anywhere from 15 to 30, depending on the industry. Anything higher could mean a stock is overvalued. Conversely, stocks with multiples of less than 15 (not uncommon in today’s beaten-down market) are favored among bargain hunters.

Focus on cash flow

Another metric that can help determine whether a stock is relatively cheap or expensive is its cash flow multiple, or its market value compared to the amount of cash it generates.

The price-to-cash-flow ratio is not widely reported, but it is easy to calculate and some believe a better barometer of a stock’s true value.

Simply divide the stock’s market capitalization by its free cash flow for the most recent fiscal year, which can be found in the company’s earnings reports.

Like the P/E ratio, a company’s market capitalization can be obtained by typing in its ticker symbol in the stock quote field of most investment Web sites.

If the free cash flow ratio is higher than that of other companies in the same industry, it’s expensive and may be overvalued. If the multiple is lower than that of its peers, it’s cheaper and may be undervalued.

“When a stock is trading well above its estimated intrinsic value of all future cash flows, that’s a good time to consider selling,” says Larson.

Beware the outliers

Another reason to sound the alarm on a particular stock or fund is when it consistently loses more than its peers — not once or twice, but over a period of several years.

“This is not a red flag,” says Larson. “It’s a yellow flag. It’s a chance to go out and do more research to find out what the market may be seeing that you are not. But remember, just because something is underperforming doesn’t mean your initial (decision to own it) is wrong.”

For stocks, be sure to compare your company’s return to direct competitors and its overall sector.

For funds, compare its annual returns against an appropriate benchmark, such as its category peers or a related index. For example, the performance of a large-cap growth fund may be compared to that of the Standard & Poor’s 500.

It may seem counterintuitive, but it’s also a good time to consider reducing your exposure to an investment if it’s posting unusually high returns, says Ryan Leggio, a mutual fund analyst with Morningstar.

“If an investor is only in it for the great return, they’ll probably end up selling at the wrong time — when there’s a temporary downturn in the fund,” he says. “Also, as we saw with emerging markets last year, when you get returns far in excess of what you’d expect that company or fund to achieve, you might be in bubble territory.”

Rather than dumping it entirely, however, consider scaling back your exposure by selling an amount necessary to rebalance your asset allocation, since high fliers eventually overweigh your portfolio towards a single asset class.

Check new management

New management is another reason to review your investment choice.

A new chief executive may have different plans for a company’s product lines or growth opportunities, which could affect the value of your stock down the road, while new fund managers may employ a different investment strategy altogether.

If you start seeing large cap growth stocks in the top five holdings of your small cap value fund, it’s time to reconsider its place in your portfolio.

“The difference between good management and bad management is night and day,” says Leggio. “The new manager may not have as much experience as the one who left, or they may have a different investment philosophy, so even though the name of the fund is still the same you may not own the same fund you used to own.”

Sleep easy

Lastly, says Leggio, it’s time to bid farewell to a stock or fund if its volatility is keeping you up at night.

“That’s a huge concern right now,” he says. “Shareholders who can’t stand the volatility end up selling after a period of underperformance, usually right before it snaps back.”

Case in point: The ING Russia fund (LETRX). The highly volatile fund, which posted a 71 percent gain in 2005 and a 72 percent loss in 2008, turned in a 10-year annualized return of nearly 22 percent through June 30, 2009, according to Morningstar. Overall, an impressive long-term return, but few investors could take the heat.

According to Morningstar, over the same 10-year period, the annualized investor return for that fund (which measures how much investors actually earned) was just 14 percent.

“Although it performed well over the last decade, it was hard for many investors to stomach all the dramatic up and down swings,” says Leggio. “That means many investors bought high and sold low.”

Stick to a system

As many investors learn the hard way, it’s easier to buy a stock than to sell.

If the recent market meltdown has taught us anything, though, it’s that all investors (the buy-and-hold crowd included) need to establish a system to mitigate downside risk.

“The most important thing is to not let your gut get in the way,” says Leggio. “Have a plan (for determining when to sell your investments) written down, review it with your financial planner and stick to it through times of volatility.”

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