A few years ago, John Rekenthaler, Morningstar’s vice president of research, narrated a story that harks back to the Soviet Union. One woman saw another standing in a long line, snaked across two blocks. "Come, I saved you a spot," said the second. "What's in the store?" asked the first. "I don't know, but everybody seems to want it, so it must be worth the wait," responded the woman in line.
John went on to draw an analogy with investing stating the same underlying reason why speculators purchased cryptocurrency. Bitcoin became desirable because people wished to buy it, and even more desirable when its price soared. The popular basis for owning cryptocurrency has been, quite simply, because today's quotes will be higher tomorrow.
The same goes with art. There is a difference between the commercial price of an artwork and its value. The price is determined by market conditions, size of the work, the medium on which it has been done, the artist, the rarity of the painting etc. The value is its perceived worth or a subjective opinion of the viewer and the demand. That is why at an auction, the actual price for which it is sold could be much higher than the reserve price estimated, simply due to competitive bidding which indicates demand for a product.
"Your wealth is in many ways dependent on what other people will pay for your assets." - Peter Bernstein, finance historian, author, and risk expert.
This also applies to stocks. Think market price and fair value.
Many investors want to know whether they should sell in such a raging bull market. But, should they sell?
Equity markets never move in straight lines. And the idea of a perpetually rising stock market is deeply flawed. But knee-jerk reactions can induce a person to act rashly and make things worse in the long run. Here’s how to make a sound judgement.
A friend recently lost his job in a financial firm, and told me that he can survive for a few months without an income. Though his wife earns too, he was contemplating selling a few investments. Fortunately, he got a new job rather quickly. If you need the cash, whatever be the reason, you may need to liquidate some investments to help you tide this crisis. Capitalise on the market rally.
- Where’s retirement on your radar?
If you are saving for retirement many years down the road, there is no reason to sell. But if you are five years away from retirement, it is certainly wise to begin offloading your equity holdings. Given the interest rates, retirees could trim their equity exposure a bit and move the proceeds into fixed income.
- Have you rebalanced your portfolio recently?
Has the market's rise driven your equity allocations higher, making your portfolio much riskier than what you intend it to be? It would be wise to ease up on your equity allocation.
People often put off asset allocation. There’s inertia exacerbated by human beings’ natural aversion to messing with a good thing; the bull market has been a boon to portfolio balances. But if you haven’t been actively trimming your portfolios’ stock positions, and if you have been actively adding to stocks amid the runup, your portfolio might be dangerously out of sync with your pre-determined asset allocation.
Your current portfolio must resemble the appropriate blend of risky and safe assets. Letting a portfolio run in a raging bull market could lead to a portfolio with a higher drawdown risk because of its higher equity allocation. And if you do not rebalance, the recovery period would be much longer because the portfolio has to climb out of a deeper hole.
For instance, those who invested in mid caps saw their portfolios grow 2.5 to 3 times between 2014 and 2017. Instead of withdrawing from smaller fare, people kept investing more into small and mid caps. Then came a 50-60% correction up to April 2020. If they had cut down their exposure after the sharp run up, they would have protected their portfolio from this drawdown. The same behaviour is evident in the recent small-cap rally.
The journey of a buy-and-hold portfolio can be tumultuous, but rebalancing can help smooth out the ride. While you can make the sell decision through the prism of asset allocation, rebalancing need not be only between asset classes, but also intra-asset class.
If you don’t think the market will rise much longer and would like to book profits, but are still tethering on uncertainty, use the principle of regret minimization. It helps give direction when facing trade-offs. Sell or hold? Buy or wait? Follow it up with: If I end up making a mistake, which mistake will I regret less?
In addition to the above, here are some useful questions whenever a sell crops up:
- What action will move me closer to my long-term goals?
- Has anything fundamentally changed with the investment that I want to sell?
- Has anything fundamentally changed with my goals?
- Has anything fundamentally changed with my investing strategy?
- Has anything fundamentally changed with my risk profile?
- What would be the tax implications of selling?
- If I sell, do I know what to do with the money? Do I need it for an emergency or expense, or do I have another investment to park it into? Is there a stock that is undervalued that I would like to increase my exposure to? Is there a fixed income investment with an appealing yield?
Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter