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."
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.
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.
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 taxesIt 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.