Stocks: When To Hold `Em, When To Fold `Em

Are you fighting the urge to rush out and sell all your stocks? Well, keep fighting. Many people never realize the potential gains of equity investing because they sell at the wrong time. "People always sell too quickly on the upside and hold on too long on the downside," says John Markese, president of the American Association of Individual Investors. Mutual-fund investors are also prone to selling when returns dip, then miss out on the recovery that typically follows.

Holding 'em when your gut tells you to fold 'em may be tough advice to follow in these times of rampant market pessimism. Although some bulls are still sticking their necks out, predicting the Dow Jones industrial average will soar above 4000, more and more bears are pointing to signs that stocks are overvalued and predicting a correction (about a 10% decline) or a full-fledged bear market (as much as a 25% drop).

TAX PAINS. Even pros who sense danger advise against selling into a downturn. "Pare back if you want, but don't sell everything," says Michael Hirsch, vice-chairman of Republic Asset Management and an operator of multifund mutual funds. He has about 40% of assets under management in cash, ready to plunge back into a bear market.

Individual investors are prone to other selling mistakes. A typical one is unloading a healthy stock that is rising steadily just to take a profit. If your equity holdings are performing well as the bull market continues, "you don't get out," says Kenneth Heebner, manager of CGM Mutual Fund. Let profits run until something happens that makes selling necessary.

If you sell at the wrong time, not only do you miss out on potential future gains but you also incur tax consequences. Remember that whatever profits you are taking will be diminished by a 28% capital-gains tax, possibly more if you didn't hold the stock for a year, says Arthur Bonnel, manager of the MIM Stock Appreciation Fund.

The flip side of selling too early is selling too late because you can't bear to part with a treasured stock, even though it is declining steadily and its prospects look dim. "Don't marry your stocks" is a familiar mantra of investing. "You have to look at it unemotionally every time," says Daniel Miller, manager of Putnam's New Opportunity Fund.

To avoid these pitfalls, develop a sell discipline and put your equity holdings to the test whenever something material happens to affect the stock price or the fund returns. Look at your holdings as if you were considering buying them today. "If it is no longer a buy, then it is a sell," Markese says.

Too often individual investors buy because one person tells them to and sell because someone else recommends it, says Bonnel. "They are selling for totally different reasons than they bought it," he says. But as irrational as it can seem at times, the market is intelligent, money managers say, and investors have to behave rationally to reap its rewards.

ART FORM. For a stock to be a buy, companies must demonstrate earnings growth, have compelling valuations, and prove an ability to execute a plan for continued growth, says Fred Kobrick, manager of MetLife-State Street Capital Appreciation Fund. He sells if the stock meets his estimated price target or if management starts experimenting with a new strategy or fails to execute a plan. "There are three legs to the stool," he says. "To buy, you have to have all three; to sell, take any one away, and the stock is done."

A sell discipline doesn't mean deciding to sell every time a stock doubles or declines to a certain point. "That is artificial," says Markese. "Fixed rules are usually dangerous." The most important factor--personal-judgment--is impossible to quantify. "There is a lot of art in this," concedes Kobrick. Beyond that, the selling strategies of most money managers boil down to a few simple principles that apply to both mutual funds and stocks.

First of all, only sell based on performance if your stock or fund has fallen in comparison with a peer group. Remember that fund managers who recently posted dismal results are likely to have invested in stocks that just fell, and their portfolios could be poised to bounce back.

Likewise, if a stock or mutual fund does badly, the market may just be rotating away from that sector or investment style temporarily. With mutual funds, know what the major holdings and most heavily weighted sectors are to understand why returns rise and fall. With stocks, keep an eye on the valuation and fundamentals as you follow price movements. Did earnings per share come in below consensus expectations? Is the price-earnings ratio much higher than comparable companies? (If so, your stock may be overvalued.) In general, the more research you do, the less you have to worry about price fluctuations. The price will eventually reflect a good stock's intrinsic value, says Miller.

Major news that affects the company or major holdings of a mutual fund can override fundamentals. For example, pharmaceutical stocks began to fall as soon as Bill Clinton, who promised health-care reform, was elected. "When government starts nosing around in an industry, that's a good sell signal," say Bonnel. Sometimes even professionals don't know why a stock is doing poorly, but they get out anyway. "If it goes down, and you don't have a good feel for it, it's better to get rid of it," says Kobrick. "There are a lot of fish in the ocean."

If a stock or fund is underperforming relative to its peer group, six months to a year is plenty of time to allow it to turn around, although some mutual-fund managers would like to have a full market cycle, about five years, to prove themselves. "A year gives you some tax potential," Markese says, because you have to hold a stock for that long to qualify for capital-gains-tax treatment, which is preferential for taxpayers above the 28% income tax bracket.

Another key to deciding when to sell is knowing who is in charge. Look for turnover in top decision-makers or signs that a strategy is floundering. This is doubly true for mutual-fund investing, where "you're buying someone's talent in investing stocks," says Hirsch. Although a change in manager is a red flag, it is not always a reason to sell. When the well-regarded Peter Lynch left Fidelity's Magellan Fund, many investors feared the star fund would go downhill. But under replacement Morris Smith and now Jeff Vinik, the fund's returns have continued to soar.

SWITCHING HORSES. Keep a close watch on portfolio managers when the fund gets large and unwieldy. Aggressive growth managers in particular may have trouble finding enough small companies in which to invest. Also, watch for managers who change investment philosophy or veer from a stated objective. Lack of candor or potential problems with compliance are reasons to sell at once.

If your investments are performing well, stock fundamentals are holding up, the management is solid, and you still want out, look at yourself. "If you are going to watch the daily stock quotes with extreme trepidation, then you don't belong in the market," Hirsch says.

Some worrying goes hand in hand with investing in equities. But if you develop a disciplined strategy and stick with it, you can sell because you are ready to use the money for retirement, your child's education, or whatever goal first motivated you to get into equity investing. Then you will be selling for the best reason of all.

        -- Performance is poor relative to similar mutual funds, or to companies in 
      the same industry and sector. 
        -- You lose faith in management either because the company or the fund is 
      experimenting with a new strategy or you sense a lack of candor. A change in a 
      mutual fund's portfolio manager is crucial to monitor.
        -- The stock price is no longer reasonable in relation to company 
      fundamentals, such as earnings and dividends. Be wary of high debt as a 
      percentage of capital. For mutual funds, make sure the manager abides by a 
      stated "sell discipline" that takes these factors into account. 
        -- External forces are unfavorable. The company's products may be becoming 
      obsolete or its market could be shrinking. As in the case of drug stocks, 
      government intervention is often a good time to clear out of a sector. 
        -- Your emotions are getting in the way. Don't get so attached to a stock or 
      a fund that you won't sell if it takes a dive or never performs to 
      expectations. Also, if you are so worried about a company or a fund that you 
      can't sleep at night, dump it.
        -- You need to diversify your holdings or adjust for your changing risk 
      tolerance. But the best reason to sell is because you've achieved your goal and 
      want to use the money to retire or pay for a child's education.
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