Many investors today have paper losses of hundreds, if not thousands, of dollars in the stock portion of their taxable investment accounts and tax-deferred retirement savings plans. Some are undoubtedly wondering whether now is a good time to cut their losses and sell. Intellectually, of course, we know that stock prices are very volatile in the short term. Experiencing it in "real time" is another matter.
As all current investors know, it is very painful to make an investment and then see the money "disappear" (at least on paper) as fast as it is deposited. A major source of risk for stock investors is market risk, which is where the prices of individual securities are affected by the volatility of financial markets. That is why it is never a good idea to put money in stock (or stock funds) for goals that are less than five years away. Two other recommended precautions are to not place more than 5% of assets in any one company and no more than 10% of assets in any industry sector (e.g., technology).
What are good reasons to sell stock or growth mutual fund shares? If you've reached a goal and need the money, a major change in fund policies or management, and sustained poor performance compared to market indexes such as the Standard & Poor's (S&P) 500 and peer funds. Also, a realization that a fund is not what you thought it was (i.e., it is too aggressive for your risk tolerance level).
A much better way to sell an investment, however, is according to a plan. It's a good idea to have a pre-determined sell "trigger" (e.g., when a fund is up 25% from its original purchase price) to sell all or part of your shares rather than to simply react to negative economic news and sell in a panic.
History tells us that market timing (trying to catch the highs and lows of the market) is futile. People who get out of stocks during slumps like we have now often miss the best trading days where the market rebounds. By the time they are convinced that the market is going up, they've lost substantial opportunity to recoup their prior losses. As proof, consider these numbers.
The S&P 500 stock index had a 12.94% average annual return through December 31, 2001. If you missed the best 10, 20, and 30 trading days during this entire ten-year period, however, the return dropped to 8%, less than 5%, and less than 2%, respectively. Another disadvantage of market timing is increased investment expenses (e.g., brokerage fees) and capital gains taxes.
Market downturns have a way of exposing an investor's true risk tolerance. That's because research indicates that investors feel the pain from losses twice as much as the pleasure from gains. Consider selling an investment if is too aggressive for your risk tolerance level and you can't stomach the volatility. Try to use the loss to offset another gain.
Don't abandon stocks altogether, however. They are your best chance for long-term growth. Consider a "total stock market" index fund that is broadly diversified and mirrors the performance of the entire U.S. stock market (Wilshire 5000 index). Dollar-cost average regular deposits so that you are buying shares "on sale" during market slumps.
Remember that stock investing is a long-term proposition. History tells us that that stocks outperform other asset classes, especially in time periods of ten years or longer. Patience is an important factor in investment success.