Stocks: Know when to fold 'em
Cutting your losses can be emotionally tough. These ground rules can help you overcome your fears.
(Money Magazine) -- After the market dealt you one bad hand after another over the past decade, you may feel relieved that your luck is finally starting to change. Stocks have shot up more than 50% since early March.
But now comes the hard part: deciding if it's time to cut your losses in some shares now that you've at least made up a little ground. There's a strong case for doing at least a little selling. Though you're probably feeling better about your portfolio than you did a year ago, stocks aren't cheap anymore -- not after enjoying their best six-month run since 1938.
And though the economy is improving, the recovery is still shaky. Then there's the fact, rally or not, that your shares likely are worth less than what you paid for them. And with year-end tax-selling season nearing, strategic selling could make sense.
Here are some simple guidelines to help you decide whether to stay at the table or cash in.
Maybe you really want to sell, but you've decided not to pull the trigger until you recoup all your losses. This sentiment is so common there's a term for it: loss aversion.
Investors don't like to sell stocks that are down because that would be admitting that their original buy decision was wrong, says Hersh Shefrin, a behavioral finance expert at Santa Clara University. "It's their egos that get in the way."
But the market doesn't care whether you made or lost money in a stock. So forget what you paid -- it has no bearing on the future price.
Rather than fixating on your purchase price, consider what the stock is trading for now. Then ask yourself, Would those shares be worth buying anew at today's price?
To answer that, it's useful to compare a stock's current valuation against that of its peers, says Tom Forester, manager of the Forester Value Fund. If a stock's price/earnings ratio -- or an equivalent measure -- climbs above its sector average, Forester will typically sell. "At that point," he says, "we can find better opportunities elsewhere."
Say you own Starbucks (SBUX, Fortune 500). After a huge rally since March, its shares trade at a steep premium to their peers. Yet lattes aren't nearly the growth story they were a few years ago, when consumers didn't think twice about spending $4 for a cup. And the stock is still down more than 30% from late 2004.
At the very least, make sure the reasons for liking a stock are still there. You may have purchased Citigroup (C, Fortune 500) shares years ago, for example, because of its global dominance and earnings potential. But it's a much smaller bank now, and Uncle Sam owns a third of it. Plus the stock has quadrupled since March, yet it's still off more than 90% from its high.
Once you've decided to pull the plug, you have another decision: dump all at once or sell gradually?
If you've concluded that your portfolio is better off without a stock, the logical response is to sell it all. If you need help getting past the psychological hump of letting go, try the incremental approach.
Unloading, say, a fourth of your position every quarter removes the fear of missing out on a rebound. That fear can be pronounced in a market like this, says John Nofsinger, author of "Investment Madness: How Psychology Affects Your Investing." When stocks are rising, investors fear missing gains, not the risk of suffering losses. "The irony," he says, "is investing becomes riskier after prices have shot higher."