Investing dogma calls for being conservative when you feel bearish. If you think a market meltdown is coming, then bonds or short-term investments are safer than stocks, which are likely to take a bigger hit. But moving to safe investments too soon could mean missing out on future gains if the market continues to climb.
Unfortunately, this is exactly what a number of investors have done lately. “We’ve watched small batches [of investors] abandon this bull market at the wrong time on a nearly daily basis,” says Craig Birk, executive vice president of portfolio management at Personal Capital in San Francisco.
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Many of these investors sold out of a “fear of heights,” he says. They were scared out of the market by the repeated “all-time highs” it kept reaching. After all, a market that has already surpassed its previous best can’t possibly continue to rise, or can it?
Record highs “feel and sound unnatural,” Birk says, but this is exactly what the market is supposed to do. As long as the government keeps printing money and the economy keeps growing, stock prices will continue to rise, he says. They just don’t always go up in a straight line. Overall, “the market goes up more than down, so if you sell out, the odds are against you,” he says. “For those who bailed out early and have been watching the party from the backyard, it has been painful,” as the market has continued to climb even higher.
The higher the market goes, the more investors get locked into the psychological trap of not buying back in because a stock’s price is higher than when they sold. As human beings, we are behaviorally predisposed to latching onto the price at which we buy or sell a stock, says Todd Wenning, a research analyst for Johnson Investment Counsel in Cincinnati. We base our decision to trade on how today’s price compares to our cost basis, when buying and selling should be a question of the stock’s current valuation, not its historical price.
Face the facts. Accepting what’s done is done is the first step to recovering from a premature sale, says Andrew Crowell, vice chairman of D.A. Davidson & Co. Individual Investor Group in Los Angeles. You don’t want to compound the problem by trying to time your re-entry. “The challenge behind timing the market is you have to be right twice: You have to time the exit and the entry properly,” he says. “Usually there are spikes either down or up that make the entry or exit timing really difficult, and research shows that most experts can’t do that effectively.”
In addition, “research shows that missing the market’s biggest trading days can impair your long-term returns,” Wenning says. “So there is an opportunity cost for being out of the market, which is why it’s critical to stick with your plan and focus on the long term.”
He suggests investors avoid falling into the trap of selling too soon by keeping a journal of each investment and noting why they bought the stock, what they think it’s worth and so on, and then revisiting the journal each quarter. The journal is there to clarify your investment plan and prevent what Wenning calls “thesis drift,” or “when you mentally alter your original thesis to fit current market trends.”
[See: 8 Times When You Should Sell a Stock.]
Before developing a re-entry plan, Crowell suggests asking why you sold the stock in the first place as this might help you find the right path back in. If you thought the stock was overpriced, then selling and re-allocating to lower-priced investments was probably the right move. If fear of market swings drove you to sell, your previous allocation may have been too risky. In that case, when you re-enter the market, consider doing so more conservatively. “Having the proper allocation will help you stay disciplined during emotional times in the market,” Wenning says.
Two ways to get back in. After adjusting the allocation, you can develop a re-entry strategy. Crowell recommends two methods for jumping back into a prematurely sold investment: dollar-cost averaging or market limit orders.
With dollar-cost averaging, you periodically invest a fixed dollar amount no matter what the market does. This strategy neutralizes the risk of bad timing so that you’re buying more shares when the price is low and fewer shares when the price is high. Dollar-cost averaging takes the emotion and guesswork out of trying to accurately time the market, Crowell says.
Limit orders can serve a similar purpose by allowing you to specify the price at which you’d like to buy shares of a stock. For instance, an investor who wants to buy back in if a stock falls 5 percent can set a limit order for that price. If the stock drops to the limit price, a market order will be triggered to buy a preset number of shares.
A limit order doesn’t guarantee that the purchase price will be at or below your limit order. Rather, once the limit order is triggered, you will get the next available price in the market, be it higher or lower than the trigger price. With limit orders, you also run the risk of being left out of the market for an indeterminate time because there is no way to know when or if the price will fall to the limit you set.
Nevertheless, limit orders let investors ease into the market by placing orders at different price thresholds. You can set limit orders simultaneously for various thresholds such as 5 percent below today’s market price, 10 percent below, 15 percent below and so on. In this way, you would be “systematically adding to your equity exposure,” which Crowell says is a more prudent and balanced way of re-entering the market than diving in all at once.
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Both limit orders and dollar-cost averaging allow you to say that at these price levels or in these dollar amounts, I’m going to buy back into the market, Crowell says. And in the long-run, investors are better off in the market than out of it.
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What to Do When You Sell Stock Too Soon originally appeared on usnews.com
