With investing, timing is everything, and getting it right rarely happens. According to Dalbar, investors guessed right about the market’s direction 75 percent of the time in 2015, but on average, they were unable to match the pace of market returns. Over the past 15 years, trying to time the market has cost the typical mutual fund investor roughly half the returns that person would have enjoyed by buying and holding a Standard and Poor’s index fund.
“Too many investors think they can get out of the market before it goes down, then get back in for the rebound,” says Daniel Kern, chief investment officer of TFC Financial Management in Boston. Investors are either overconfident about their market-timing abilities or susceptible to mood swings that influence their investment decisions, he says.
Buying an investment is easy, particularly when the market is riding a positive wave. Determining when to sell, on the other hand, can prove more challenging, and getting it wrong hurts investors in more ways than one, says Rusty Vanneman, chief investment officer of CLS Investments in Omaha, Nebraska.
First, there are the transaction costs to consider. Selling an investment may trigger commissions or other fees, and higher costs mean lower returns, Vanneman says. Second, too few investors understand market cycles. For instance, many investors sell out of fear as the market is trending downward, potentially sacrificing returns when prices inevitably rise again. Or, they may hold onto a losing investment in the hope that it will eventually rebound.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
From a retirement perspective, you can’t afford those missteps, but having an exit strategy gives you an impartial way to determine when to keep an investment and when to let it go.
Decide how much you’re willing to lose. Whether the market is up or down, your decision to exit an investment can affect your retirement plans. Chris Dixon, CEO of Black Harbor Wealth Management in Seneca, South Carolina, says investors should have a road map they can refer to when in doubt about whether to hold or sell. “Think about getting in the car to go on vacation. You’ve most likely planned your trip ahead of time. Retirement should be approached the same way,” Dixon says. Look at the investments in your portfolio and see if they’re designed to meet your retirement income needs.
Just as selling an investment too soon can harm your portfolio, so can holding on to an investment too long. While a buy-and-hold strategy may deliver more consistent returns over time, you should still know how an investment performs and whether you’re on track to meet your retirement goals.
This is where your individual risk tolerance also comes into play. Dixon says that investors must know how much money they’re comfortable losing to avoid making irrational decisions. Having a set number in mind can help you act rationally so you’re not selling too early — or too late.
For example, setting up a stop-loss order is one way to insulate your portfolio from steep losses. You determine the price at which you want to sell a stock, based on how much money you’re willing to lose. If the stock falls to the stop-loss price, an order to sell is automatically triggered.
Mike Windle, a retirement planning specialist at C. Curtis Financial in Plymouth, Michigan, says stop-loss orders can offer investors a measure of protection against losses they may not be able to sustain. This approach may be better suited to investors who tend to be more hands-off in managing their investments, however.
[See: 10 Skills the Best Investors Have.]
Of course, setting stop-loss orders isn’t a perfect solution. Carrol Schleif, deputy chief investment officer for Abbot Downing in Minneapolis, says stop-loss orders can be dangerous, especially when market volatility is high. In a fast-moving market, the sale price when the order goes through may be far below the price you initially set. In that scenario, you could undercut your investments significantly. She says dollar-cost averaging may be a more reliable way to mitigate losses over time, versus taking an all or nothing position. With dollar-cost averaging, the risk of timing the market wrong is spread out by investing regularly in equal amounts.
Account for taxes. Aside from transaction fees, taxes are another cost to consider when exiting an investment. Dixon says investors need to determine what the capital gains tax will be before selling and how much the taxes will bite into their profits. Investments held for less than one year are subject to the higher short-term capital gains tax rate, while investments held longer than a year receive more favorable tax treatment.
If you have losses as well as gains, there’s a silver lining, Windle says. Losses can be harvested to offset gains, possibly reducing your tax liability. For example, a $10,000 gain can be balanced out with a loss of the same amount. If you have losses that exceed your gains, up to $3,000 of that can be carried forward to balance out gains in future tax years.
Make portfolio rebalancing your guide. Your cue to exit is when your portfolio needs rebalancing. It’s a means of controlling risk, says Ken Moraif, a certified financial planner and senior advisor at Dallas-based Money Matters. When you allow one portion of your portfolio to become too large, the hit is especially deep when those investments lose value. Rebalancing regularly can ensure that you’re not overweighted in any one investment or sector that could suffer losses.
What you must concentrate on, however, are the merits of your investments, rather than your feelings about them. Schleif says investors should look at the fundamentals of their investments and rebalance accordingly. If an asset class has become overvalued, for example, but the investment itself remains strong, you might trim back some of your holdings instead of selling them entirely.
Your investing horizon should be considered when rebalancing, Schleif says, as “the longer you can leave your assets alone, the longer you can focus on accepting more risk.” What might seem like a crisis may just be a temporary blip in a stock or fund’s performance, in which case, you may be better served by delaying your exit.
[See: The Fastest Ways to Lose Money in the Stock Market.]
Reviewing an investment’s historical performance can help you identify trends in pricing so you know what to expect long term as you rebalance, Windle says. The key is knowing how much risk you should take for the return you need. “Everyone likes to talk about risk tolerance, but risk need is more important,” Windle says. “Whether you need 10 percent or 1 percent can make a big difference in how you’re invested and when you make your exit.”
More from U.S. News
The Top 10 Investment Portfolio for Millennials
13 Ways to Take the Emotions Out of Investing
3 Steps to Forming an Investing Exit Strategy originally appeared on usnews.com
