When should you sell an investment if the value drops?

Investors agonize over this and often let themselves be guided by the old adage: “Buy low, sell high.” Based on this logic, they decide they will hold any investment they buy until they can at least break even. Once a client adopts this mantra, it is difficult to convince them to sell their holding at a loss, even when it keeps dropping in price.

There is a strategy of ‘averaging down’ when an investment drops in price. For example, suppose that you buy a mutual fund or stock when it is $20 a share and then it drops to $15 a share. If you had decided it was a good buy at $20 then, logically, you should buy more because it is even a better buy at $15. And if it drops to $10, then buy even more.

This is an aggressive strategy, and requires undaunting confidence in the investment. It can work out, but it often doesn’t. When it doesn’t, the results can be catastrophic. Employees who buy their company stock are particularly prone to make this mistake.

I have seen situations where clients have stubbornly held on to Pan Am, GM, Chrysler, Enron, etc. and continued adding to their holdings only to end up losing it all. On the other hand, Ford shareholders have done well using this strategy over the past few years.

A more sound investment approach is to decide that, when you buy an investment, you will reevaluate it if it drops. You evaluate the losing investment with other investments, and then make a “keep or sell” decision. For example, let’s go back to your $20 per share stock. Rather than wait until it drops to $15 you could have decided that, if it drops 10% or 15% (i.e. to $18 or $17), you will reconsider the investment.

If there are other investment options with better upside potential, sell your loser and reinvest in something with better prospects. This prevents you from blindly holding on to the shares hoping they will go back to $20.

For many people, selling a loser means they made a mistake, and they are adamant about not losing money on their investments. The blatant truth is that holding on to the stock means you still have a loss, you just haven’t ‘realized’ it yet.

One technique I have used with some success is to explain to clients that by selling the stock, they are ‘harvesting’ their losses for tax purposes. The tax loss will save them tax dollars by offsetting other gains, thereby reducing the capital gains tax. It often gives them an additional $3,000 deduction against other ordinary income, which can save them about $1,000 in taxes at the 33% tax bracket.

The beauty of this is that the client can buy the stock back after 31 days. If bought back sooner, the ‘wash sale rule’ precludes them from taking the tax loss. It’s interesting to note that, no matter how resistant the client was to selling the stock at a loss initially, once they sell it they never buy it back!

Of course we do not recommend ‘market timing.’ When managing clients’ portfolios we take into consideration other factors such as the overall balance of the portfolio, the amount of the single investment relative to the total portfolio, as well as tax issues and clients’ long term goals.

For example, we don’t sell stripped Treasuries in a client’s ladder just because the market value drops. The function of this investment is to assure that the maturity value provides the cash flow necessary for spending goals (usually in retirement), without fail. We know and expect that the market value will fluctuate in the meantime, but the ending value is government guaranteed.

On the other hand we don’t hesitate to sell a mutual fund that has underperformed its peers significantly for two or more quarters in a row. We also take losses in the Cambridge Index Portfolio when we can capture them as short-term, which are the most tax advantaged.

Cutting losses isn’t limited to securities like stocks, bonds, and mutual funds. A huge concern of many clients today is whether they should ‘dump’ their real estate in this depressed market or wait until they can ‘get their money back out.’ This issue is more complex, but here are some guidelines I consider.

If the home is your personal residence, and you like it and can afford the payments, keep the house unless you have to move (e.g. new job, changing neighborhood). If it is a vacant house or vacant property, it is generally better to sell (even at a loss) because the carrying costs of keeping vacant property and running the risk that the value will continue to drop generally makes this type of real estate a bad investment at this time. You may want to review my previous blog of April 29, 2010 titled “What To Do When Your House Is Underwater.”

The issue of when to “cut your losses” is also perplexing when applied to employment and other relationships, but my expertise in these areas is limited (though I have done a lot of research…). The best approach usually is to get a therapist!

In any situation, cutting your losses sooner rather than later is usually the better course of action. Not only does it minimize financial losses, but it also reduces stress. Continually dealing with these kinds of decisions is emotionally toxic.

So make a New Year’s resolution to cut your losses in three areas that have been plaguing you. Get the monkeys off your back, and get on with a rich fulfilling new year!

Guest post by BY: Bert Whitehead, M.B.A., J.D.

Photo

Daily we are bombarded with horror stories in the financial media about how severe the current recession is.  It has unofficially been named “The Great Recession” making a very uncomfortable connection to the Depression of the 1930′s.

So just how bad off are we?  Should you prepare yourself as if we are entering or are already in the next depression?

In this guest post, Kennith Robinson shares real information, not the hype the media uses to sell their products, to put the current economic climate in perspective.  Enter Ken:

In February 1954, Time magazine and the St. Petersburg (FL) Times quoted labor leader Dave Beck: “I define a recession as when your neighbor loses his job, but a depression is when you lose your own.” His comment, which became a popular saying, captures how challenging it can be to distinguish between a recession and a depression.

Are we actually in a depression now? As bad as things have been, and despite the comparisons you’ve probably heard, this recession is not another Great Depression.

There is no single definition of a “depression.” When real gross domestic product (GDP), a measure of the size of an economy, drops by 10% or more, economists commonly describe the situation as a depression. But this recession has so far been marked by only a single-digit decline in real GDP (less than 4% through the end of March 2010). By contrast, real GDP declined by more than 26% during the depression of the 1930s.

What about unemployment? Rates have been high, especially in some areas of the country. According to the Federal Reserve, nationwide unemployment has so far topped out at slightly above 10%. That’s hardly good news. But it’s not nearly as high as the estimated 25% unemployment rate of the 1930s.

Also, far fewer households 80 years ago had two earners. It’s always upsetting when someone loses a job. But the loss of one job in a two-income household has less impact than the loss of the only job in the household. A substantial number of families experiencing unemployment today still have some income and thus are still putting money into the economy.

A similar point can be made about unemployment compensation, which didn’t exist until the 1930s. We may think its main purpose is to help support a family experiencing a job loss. But the benefit to the larger economy is that the family has some money to spend, which stimulates economic activity and helps blunt the recession.

What about the recent spike in bank failures? After only 3 failures in 2007, the Federal Deposit Insurance Corporation (FDIC) reported 25 bank failures in 2008 and 140 in 2009. So far in 2010 there have been more than 140. But this number doesn’t come close to the roughly 7,000 banks that failed in the wake of the 1929 stock market crash (about 4,000 of those in a single year). It’s also not as severe as the fallout from the savings and loan crisis of the 1980s when about 1,600 banks failed (534 of those in 1989 alone).

In addition, the nature of a bank failure has changed. When a bank failed in the 1930s, depositors lost their entire savings. Today, when the FDIC decides a bank has failed, regulators swoop in—like a SWAT team with briefcases and laptops—often around closing time on a Friday. In most cases, by Monday morning the bank is open for business as a branch of a stronger bank. The most noticeable difference is usually that the signs for Failed National Bank have been replaced by those of Stronger National Bank.

If the situation isn’t nearly as devastating this time around, why does it seem so awful? First, the news cycle has changed. Instead of catching up on the latest events in a morning or an evening paper, news is now a 24/7 business, with intense competition for our attention.

The media makes its money by selling advertising, so the news story has to be juicy enough to keep you watching when the ad comes on. It doesn’t mean the news is necessarily giving you any information that’s helpful in figuring out what action you should take next.

Also, for most of us, the current economic conditions are far more challenging than anything we’ve faced so far in our lives. The Great Depression may have been much worse, but this situation is happening to us, not to our grandparents or great-grand-parents. Naturally we experience it as a traumatically defining event.

As we’ve seen so many times before, this kind of instinctive emotional response is often the enemy of sound financial behavior. If you have concerns about how you should respond to current economic conditions, call your ACA advisor for a clearer understanding of what you should do and, just as importantly, what not to do.

Will we have a “double-dip recession”? No one will know for sure until it happens (or doesn’t). But we have many reasons to be confident this recession won’t lead to a repeat of the 1930s.

Kenneth F. Robinson, JD, CFP® is a Financial advisor in Cleveland, OH.  Be sure to check out his new book Don’t Make a Budget

***

Photo

****

Did you enjoy this post? If you’d like more like it, please share it through your favorite social media by clicking the buttons below to let me know.

Please share your experiences and ideas by posting comments below.

 “Retirement Plan Investment Tip”

 ·         If you had purchased $1000.00 of AIG stock one year ago, it would now be worth $56.91.

 ·         With Washington Mutual, you would have $120.36 left of the original $1000.

 ·         With 'Fannie Mae'(FNM), you would have $11.34 left.

 ·         If you had purchased $1000.00 of Lehman Bros one year ago it would now be almost
worthless; less than $0.86.

 ·         If you had purchased RH Donelley, you would have $45.69 left.

But, if you had purchased $1000.00 worth of beer one year ago, drank all the beer, then turned in
the cans for the aluminum recycling refund you would have $214.00.

Based on the above, the best current investment advice is to drink heavily and recycle.

This is called the 401-Keg Plan

Daily I’m asked about the economy and at least weekly I receive a media inquiry asking me to forecast it. Rarely do I comment or make predictions on the day to day activity of the economy. I have been following and investing in the stock market for over 15 years. During those years I’ve learned that no one can predict the direction of stock market in the short run, but I am confident that in the long run it will reach new record highs. I learned this during my academic training and then reinforced it by making my share of mistakes.

Those who try to predict the market in the short term are either lucky or wrong. Large investment companies spend millions of dollars hiring investment analysts to predict the economy. Of these analysts, half are right and the other half are wrong, but none are consistently right. This is always true because for every buyer, there must be a seller, and they can’t both be right.

Most of the headlines we hear about the economy are stories of doom and gloom. We hear these stories from newscasters who know little about the economy, but are paid to sensationalize it. Face it, news would not sell if the headlines were, “Everything is going well, just stay the course.”

The more you ignore the short term economic conditions the better off you will be. Focusing on the news will more than likely lead you to make poor choices because these factors have very little impact on your goals. The headlines are beyond your control and have relatively little influence on your investment success compared to the things you can control.

For example, whether the economy goes up or down 10% over the next six months is far less important than you making the maximum contribution to your retirement plan. It’s also far less important who is elected than if you are living within your means and spending within a reasonable budget. And it’s irrelevant what happened to Enron, as long as you are invested in a well diversified portfolio where one or two bankrupt companies only represent a very small fraction of your investments.

I hope you can see from my examples that our individual success depends more on our choices. The current state of the economy impacts us far less than the media would lead us to believe. Each of us will feel the impact of the economy to varying degrees, but do not fall into the dangerous trap of believing those events control our fate—they don’t—we do. It is urgent that you “act now.” You need to act now to get the basics of your financial life in order; but not because of state of the economy.

Mom And Dad, Can We Talk About Money? -
Some helpful ideas to make a tough conversation easier.

Reasons People Fail At Investing -
Don’t make these common mistakes.

Ideas For Raising Smart Money Kids -
Many parents have questions about teaching kids about money and this article gives some great ideas.

Selling Investment Returns -
Understanding the complicated finance industry and how investment returns are sold to consumers.

Download Financial Focus-Summer 2008