When to Sell? Adopt a Plan Before You Need It

Is now the time to be selling mutual funds?

That is a question investors should always be asking themselves, but it is a bit more relevant these days, given the prices on the stock and bond markets.

Bond yields have tumbled and prices have climbed significantly over the last few years.

Stocks also have generally moved higher--to the point where the Dow Jones industrial average looks expensive in terms of dividend yields and other traditional benchmarks.

There are also some compellingly bullish arguments, such as continuing low interest rates and the baby boomers reaching their midlife investing years.

But the point is that investors should have some general game plan for deciding when and how much to sell, before the need arises.

Deciding when to sell a mutual fund is harder than determining what and when to buy. That’s because investors already have their money committed when they make a move to sell. That really opens the door to emotions such as greed and fear, which can distort judgment.

Also, it’s a lot easier to find pointers on buying than on selling. It’s not often you find headlines touting “10 Hot Funds to Unload Now.”

One way to focus on a rational selling plan is to adopt a particular investing approach. Basically, these can be boiled down to market timing, long-term investing and asset allocation. Each of these has its advantages.

Market timing describes the idea of moving big chunks of your portfolio at the drop of a hat. A typical switch might involve going 100% from stock funds into cash. Although it may involve such drastic movements, market timing aims to be a defensive approach, in that the objective is to get completely out of harm’s way while prices are slipping.

The great appeal of timing is that it allows one to sit out a bear market in safety. The 21-month downdraft from January, 1973, until October, 1974, sliced 48.2% off the Standard & Poor’s 500 index, according to Fabian’s Telephone Switch Newsletter of Huntington Beach.

The typical growth fund needed 43 months to recover from the 1973-74 debacle, according to a study by T. Rowe Price Associates of Baltimore. Since the late 1920s, bear markets have endured for an average of 17.2 months and resulted in an average decline of 37.4%, according to the newsletter.

Market timers, in short, seek to avoid such devastation.

The main problem with timing is that it is easier said than done. Timers who move money around often subject themselves to unprofitable whipsaws. By contrast, those who switch infrequently risk missing the first few powerful days of a rally.

Studies have shown that timers have to guess right on two-thirds of their sell-and-repurchase decisions in order to beat a buy-and-hold alternative, said Heidi Steiger, director of individual assets and management for Neuberger & Berman, a New York Fund family.

While it is possible for timers to beat a buy-and-hold approach over the years, it is extremely difficult.

The buy-and-hold approach is at the other end of the scale. It requires little, if any, selling. This is probably the most popular form of investing, and a method that has withstood the test of time.

A buy-and-hold orientation works especially well with equity mutual funds for two reasons: Most funds are sufficiently diversified to track the broad stock market, and the stock market has shown a clear bias to appreciation over time.

Mutual funds also allow for the easy reinvestment of dividend and interest income--a potentially powerful compounding factor.

Dollar-cost averaging, which involves investing small amounts in equal, regular installments, can help allay fears about risking too much cash at once. It’s an important way investors can deal psychologically with volatility along the way.

The main drawback of a buy-and-hold approach that incorporates dollar-cost averaging is that it requires a fair amount of discipline on the part of the investor.

“Most people do not have the stomach for buying stocks or mutual funds in a declining or troubled market,” said Douglas Fabian, co-editor of Fabian’s Telephone Switch Newsletter.

Sooner or later, he said, most people think twice before throwing what they perceive to be good money after bad.

Another buy-and-hold drawback involves asset mixes. Assuming you want to maintain a set percentage allocated among stocks, bonds, cash and various subgroups, you will need to readjust your portfolio over time.

Otherwise, equities will eventually overpower bonds, producing an increasingly volatile portfolio, said Jay R. Penney, a certified financial planner and analyst with the Acacia Group in Phoenix.

Penney recommends a set percentage asset mix based on the individual investor’s risk tolerance, return expectations, time horizon, liquidity needs and other factors.

A typical weighting might be 60% in stock funds, 30% in bond portfolios and the rest in money markets--with further divisions in terms of growth or value, international or domestic, and so on.

Studies have shown that as much as 93% of long-term returns are attributable to the asset class rather than the particular investment, Penney said. “The distinction between buying Fund A versus Fund B in a particular category is fairly minor.”

Penney re-balances the proportions when any classification swings more than two percentage points from the desired mix. To do so, he sells shares from funds that have appreciated and reinvests the proceeds in the laggards.

Such re-balancing keeps investors on track and periodically results in some buy-low, sell-high movement along the way. It also gives people the psychological comfort of knowing that “something is being done during volatile times,” he said.

An asset-allocation strategy of this sort represents something of a compromise between unimpeded buy-and-hold investing, with its potentially greater long-term returns, and market timing, with its emphasis on sidestepping bear markets.

Each of these three approaches has some merit and can prove successful--provided investors don’t try to follow all of them at once.