With any investment decision, there are two key decisions that have to be made. The first is when to buy and the second is when to sell. One of the most difficult investment decisions you will ever make is when to sell a mutual fund. There is an abundance of information out there on how to buy a mutual fund but when it comes to the other side of the equation, there is a big gap. Unfortunately there is no one right answer to making the right buy nor the right sell. There are many theories and arguments so I will try to tackle some of the issues you'll face on the sell side of the equation.
Buy Low, Sell High
While this may sound overwhelmingly obvious, it is a strategy that is extremely difficult to implement. Why? Because psychology or emotion gets in the way of logic. Over and over again, investors tend to do the opposite by buying high and selling low. We see this in the buying patterns and mutual fund flows. After a mutual fund has shown great performance, investors start the buying trend. For example, mutual fund flows into technology and equity products reached all time highs at the end of 1999 and the beginning of 2000 which coincidentally was also the high of the market. The problem is buying low means you have to go against the grain and be contrarian. This takes a lot of courage.
Along similar lines, some investors sell because they are trying to time the markets. Often, I hear investors say that you should get out the markets before the markets starts to fall. The problem is that market timing requires knowledge of the future and foresight of future events. The reality is I do not know anyone that can time the markets consistently over time. Sure there are people that have done it from time to time, but the problem is wrong market timing can be disastrous to a portfolio. It has been said before and I will say it again; avoid market timing because it cannot be done.
Buy your winners and sell your losers
If you took a look at your portfolio today, it is likely that there will be some winners and some losers. In fact, at any given point in time, there will be winners and losers. The most common reaction resulting from reviewing a portfolio is to sell your losers and buy more of your winners. Again, the problem with this logic is it goes against the buy low and sell high philosophy as you will be selling lower and buying higher. In fact, the best strategy is to do the opposite and sell your winners to buy your losers. This is called the strategy of rebalancing.
Buy and hold and never sell
Certainly the investment industry has done a great job at preaching the merits of buy and hold. However, there are some fundamental problems with this strategy too. The first is that in any commoditized industry, there are good products and bad products. If you buy a bad product and hold a bad product, you will always have a bad product. This is certainly true with mutual funds. The second problem is that new funds come out and sometimes new products can be innovative and become better than old products. At some point in time, change is inevitable and sells are necessary.
So what's the answer
Here are some very important tips to developing a sell strategy.
- You must have a sell strategy. Whenever I interview fund maangers, I always ask what their sell strategy is. Good managers and good investors can very easily communicate their sell strategy. It's not good enough to have just a buy strategy.
- How you buy determines how to sell. Your buy strategy should form the foundation for your sell strategy. If you have certain criteria defining what and how you buy a mutual fund, then you should sell these funds if the criteria is not met in the future.
- Focus on quality and not just performance. Quality mutual funds can go up and down from time to time. Performance is never perfect because the mutual fund industry is not perfect. The key is to find a way to define quality without being overly dependent on performance alone. Don't get me wrong, performance is important but quality can only be measure by looking at a lot more factors like risk, fees, consistency, management, discipline, etc.
- Discipline, strategy and planning. Success in the investment industry results from discipline, strategy and planning. Interestingly, there are many different strategies and disciplines in the investment world and many of these different alternatives are successful. So the key is not what discipline you preach but the fact that you have discipline. Far too often I see mutual fund investors who do not start with a plan and they have no defined strategy. Having a discipline will help you to define your sell strategy.
- Working with a financial advisor. If you are working with a financial advisor, you should make sure you know their discipline and strategy to investing. If they do not have one or can not clearly communicate one to you, then you need think twice about who you want managing your portfolio.