When to Reduce Your Stock Holdings

Investment Newsletter #2 (May 27, 1999)

Should You Be Reducing Your Stock Holdings?

Think your funds/stocks may be looking a little vulnerable right now? Given the big run-up in stocks in the last few years, should you be lightening up in anticipation of an extended correction? Generally speaking, my answer is no, but my reasons have little to do with whether or not the market may be headed for a further fall. Rather here are some considerations to ponder:

1. It is impossible for anyone to predict with long-term consistency the various zigzags of the market averages. In fact, you probably have less than a 50/50 chance of being right in the short-term (over say several months) when you guess that the market is going to go down given its long-term upward bias. Any such sell decision is, at best, no better than trying to decide whether to sell based on the flip of a coin.

2. Needless to say, if you are selling at a gain from a taxable account, you will increase your taxes. If, however, you are selling at a loss, this may indeed make sense because it can reduce your taxes.

3. Even if you turn out to be correct in anticipating a downturn, will your decision to sell a holding now prove to be smart in the long run? Only if one of the following is true:

a. you are able to find a different investment (eg. stocks, bonds, cash, etc.) that will do better in the long-run. This is why I suggest you might want to consider switching over to additional small/mid caps, value, and foreign stocks in your portfolio, since these categories seem to have the greatest potential going forward a few years.

b. you are able to buy the same fund/stock back later at a lower price. Unfortunately, this is a lot more difficult to accomplish than it sounds.

c. the price never recovers. This is highly unlikely!

d. if you need the cash now or in the near future for some other non-investment purpose, then selling makes sense too.

So, immediately after selling, even though it may temporarily seem like a good decision, especially if the price starts by falling further, unless one of the above 4 things turns out to be true, you are usually NOT better off in the long-term for having sold. In fact, too often, before not too much time has elapsed, the price you sold at winds up being surpassed.

Should You Be Increasing Your Non-Stock Investments?

If you want to reduce your susceptibility to a market correction, investing in bonds and/or other non-stock holdings, including cash would be one way to accomplish this. However, you should realize that such investments will never outperform stocks over extended periods of time. (They may help you sleep better at night though!) And as you approach or enter retirement, they may help supplement your income through dividend payments.

As I stated in my last letter, I don't think this is a particularly good time to buy bonds. Ideally, buying bonds makes the most sense when interest rates are fairly high and do not seem to be going any higher. If you are fortunate enough to buy bonds once interest rates have reached a peak, not only will you receive relatively high dividends but the underlying value of your investment will increase as rates come down.

Interest Rates

Given the continuing strength of the economy and the Fed's own now publicly stated bias towards raising interest rates, it is very reasonable to assume that rates will be going higher. As I stated last time, long-term rates of 6.25 to 6.50% seem clearly within reach as the year progresses. Only if rates get within that range, however, do I think bonds will once again offer a greater degree of appeal.

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