Considerations Before Selling or Exchanging Between Funds

Once you have decided on your allocations, you will have a formula in place to guide your purchases. But what about shifting balances out of funds as conditions change? Here are some things you should consider:

1. Don't be "quick on the trigger". Good funds held through the years tend to grow and grow in spite of inevitable downturns. Sales should be well thought out, not based on some immediate urge. Remember that as a mutual fund holder, as opposed to a purchaser of individual stocks, you have in effect already hired someone to be selling overpriced stocks or underperformers for you. And if you have selected your funds well, some of your fund managers may indeed be among the best professionals available to do just that. (However, this will not be true if your fund is an index, such as the S&P 500.)

2. When selling, consider doing it gradually. Almost everyone had heard about dollar cost averaging, the technique whereby you buy shares gradually to reduce your risk of buying at too high a price. But selling gradually is a strategy I personally have found has helped me even more by preventing me from selling at what turned out to be too low a price. And it has allowed me to continue holding super-achieving funds that my more risk-averse side said "sell". This has proven to be very wise for me as a long-term investor as my fund gains have greatly magnified over the years.

Just as no one knows the best time to buy, no one knows the best time to sell either. Yet most people just seem to arbitrarily decide one day that it's time to sell and proceed to sell off all of a certain investment. But often to their dismay, the price of what they sold then goes higher and higher.

The way to minimize this risk is to sell gradually, in much the same way as you probably bought your shares. For example, suppose you have $10,000 in an S&P 500 fund and notice that its share prices have gone up considerably since you first purchased them. Further, you decide they are unlikely to go up much further, or, you may even feel strongly that a correction will soon knock them down. Rather than exiting all at once, I have learned to sell at most 10 to 20% of the total balance in a fund at any one time, or in this case only $1000 or $2000 worth. This allows me to book a profit, but still maintain the investment. This is psychologically important because if it turns out you were wrong in your outlook, it seems as though it is much more difficult to admit this and buy back such a fund after previously having completely exited out of it.

If the price continues to rise, or after a certain set time period has passed, I will probably decide to sell another equal-sized or perhaps larger chunk. If the price falls, I at least have the satisfaction of knowing I got out of part of the investment at a good price. If it falls significantly, I may even want to use the opportunity to buy back some or all of the amount I last sold at a better price.

I have also found that such small sales may satisfy the need you have to "do something" without substantially changing your overall position. This allows you to continue to be a long-term investor and yet still feel you are doing the prudent thing by doing some selling when prices seem too high. It also allows you to re-adjust your balances when certain categories of your funds have grown larger than your original allocations.

3. Think of every sell decision (except one where you really need the cash for some other purpose) as requiring two tests, both of which must be satisfied before implementing a sale: 1) Should I reduce my position in Fund X? But also: 2) Does it make sense to put money into "Y", the place that X's funds will be targeted into? Be aware that if you are going into cash, the returns currently available are exceptionally low. So, in other words, you should ask yourself whether Y is really a better place to be than the investment you are selling.

4. In many cases, you should think twice when considering selling across broad asset categories: That is, when selling a stock fund, it often makes more sense to put the proceeds in another stock fund, than in bonds or cash. This can shield you from going too light on your stocks as you sell. (Don't forget that stocks are historically the best long term investment and any such sale will buck up against this fact.)

5. If you anticipate a downturn after a run-up in a fund's price, sell early rather than late. That is, either sell while the price is still going up, or after it has dropped just a few percentage points. If you wait too long, it may be too late to get out without losing a big chunk of your profit.

6. If you are contemplating selling an investment that has been already been performing very badly for a while, consider being more patient instead. If you really don't need the money from a sale, you can usually do better by waiting for at least a partial price recovery.