When Should
You
"Pull the Plug"?
by Paul Merriman, Publisher
FundAdvice.com
Every
investor eventually faces an important and uncomfortable fork
in the road, having to decide whether to stay the course or bail
out of a disappointing investment. Often, I am asked what a person
should do in that situation.
The topic is timely
this year, when many investors are facing disappointments. Many
investors became so excited about technology stocks last winter
that they borrowed money from brokers (using margin accounts)
or credit cards to buy aggressive stocks and funds. Many of those
people have to be mighty disappointed about now.
Most experienced investors
believe it's best to stick with something for the long-term.
But what is the long-term, anyway?
I think it's useful
to start with the notion that there are two quite different ways
to define long-term. The first "long-term" is from
the point of view of the asset. For example, if you invested
in a stock option that expired a month later, the "long-term"
for that particular asset would be only a few weeks. On the other
end of the spectrum, imagine you bought a piece of raw land because
you believe a freeway interchange will be built nearby someday.
The appropriate long-term for that asset could last for decades.
Most investments are
somewhere in between. The appropriate "long-term" for
a short-term bond fund could be six to 60 months. The appropriate
"long-term" for a Standard & Poor's 500 Index fund
might be a "complete market cycle."
But who knows in advance
how long a market cycle will take? It could be five years or
20 years. If you invested in the U.S. stock market in 1901, 1929,
or 1969, it took you approximately 20 years to break even, after
adjusting for inflation.
We're wading into murky
waters in this discussion already.
The second definition
of "long-term" is from an investor's point of view.
If you have money set aside to send a youngster to college, your
"long-term" for that money is whenever the tuition
is due. If you're saving for retirement, your "long-term"
is your expected retirement date.
This analysis suggests
that the best investment has an appropriate time frame that matches
your own. It may be easier to see this if you think about what
does not match. For instance, it's obviously counter-productive
to buy a piece of raw land in order to pay next year's tuition
bills.
In general, the more
uncertain, volatile and risky an asset, the longer its appropriate
long-term holding period. And the more stable and safe an asset,
the shorter the period that you can expect to hold it without
losing your shirt.
That
explains why money-market funds are the right place to put cash
you know you'll need in a few months. And it explains why equity
funds are the right place for cash you won't need until retirement
a decade or two down the road.
Conventional wisdom
in the investing industry says that in general, the longer you
hold a stock or a stock fund, the higher the chances you will
make money on it. But I have always thought there's a corollary
that's equally true: The longer you hold a stock or a stock fund,
the higher the chances that it will experience a disastrous loss.
The U.S. stock market experienced enormous losses in the late
1920s and early 1930s and again in the early 1970s. I think it's
foolish to think this can't ever happen again.
It's very difficult
to prescribe holding periods for assists. Asset classes tend
to go in and out of favor at various intervals that are hard
to predict. Here's an example:
Recently, U.S. value
stocks have been out of favor and have underperformed for the
past several years. Nobody knows how long this will go on. But
I'm sure this won't continue forever.
If you're invested
in a value fund, how long should you wait in order to give that
fund time to show its stuff? The correct answer is not very helpful:
Wait long enough for the fund to enjoy its day in the sun. That's
easy to say, yet very hard to do.
For a real-world example,
look at Berkshire Hathaway, the stock that represents the investment
portfolio of Warren Buffett, one of the greatest investors of
the last 50 years. In the past few decades, this company's stock
has produced many wealthy investors. The stock soared from $17.50
at the end of 1966 to $81,800 early in March 1999. But one year
later, in March 2000, Berkshire Hathaway slumped to a 52-week
low of $40,800. (It rebounded to $58,600 at the end of May.)
Having suffered a 50
percent loss in a period when the average U.S. equity fund produced
gains of more than 25 percent, how long should Berkshire Hathaway
investors wait before they bail out in disgust or disappointment?
Empirically, there's
no rational way to answer that question, because the "right"
answer requires knowledge of the future. Ultimately, the sensible
way to make a decision depends on your emotions, your level of
faith in Buffett and your tolerance for disappointment. At some
point, you may realize that you'd simply be happier, more relaxed
and more confident of the future if you sold that stock. That
may be the time for you to sell.
You could always find
somebody who thought you were wrong to sell. But that doesn't
mean you were wrong. It only means there's a buyer out there
when you're ready to sell. This is what makes markets work.
Last year we wrote
an article about small-cap investing that showed some graphs
of relative performance between large-cap stocks and small-cap
ones. In a series of graphs (you'll find them if you visit our
Web site www.fundadvice.com and look in the article library for
a piece entitled "Size Manners"), we showed dramatically
how large-cap stocks and small-cap stocks go through periods
of relative under-performance and over-performance.
From 1965 through 1998,
we identified three periods in which small-caps stocks were the
leaders, the longest one lasting for nine years (1975 through
1983). We found three periods in which large-cap stocks were
the leaders, the longest one lasting seven years (1984 through
1990).
This suggests that
more than a decade of patience might be required to get the full
benefits from investing in small-cap stocks or large-cap ones
for that matter.
However, few investors
are patient enough to hang onto an underperforming asset for
nine years. And this leads to a second major question: How long
should you wait before giving up on an investment that fails
to meet your expectations?
If your expectations
are unreasonable, then you'll be disappointed much more easily.
Early this year, some eager investors were certain that they
had finally discovered financial nirvana in the form of technology
funds.
One reader sent an
E-mail implying he thought it must be normal and common for mutual
funds to double in a calendar year. He asked for a recommendation
of a fund that would do at least that well this year, with low
risk. He and some other readers scoffed when I replied that a
15 percent compound annual return is worth aspiring to but that
I could not take him seriously as an investor if he were trying
to double his money in a year's time at low risk.
But even when your
expectations are reasonable, sometimes investments simply don't
live up to them. What should you do?
I've seen various formula approaches to
this question, but I don't think they are very good. It's easy
to say you should pull out of a mutual fund if it underperforms
the majority of its peers for three years. But for some people,
three years may feel like eternity. And there are others who
don't want to be bothered even looking at their fund balances
as often as every three years.
When I think about
this issue, I think it's similar to other areas of life where
we face disappointments and sometimes have to "pull the
plug."
For instance, how do
you know when you've waited long enough for a new employee to
perform up to your expectations? How long do you keep a "lemon"
automobile before you simply cut your losses and try to sell
it to some other poor fool? How long should you stay in a bad
relationship or in a job that isn't really suitable for you?
There are no reliable
rules for those situations. Some people simply have a lot of
patience, while others have little. Ultimately it comes down
to something simple and hard to measure. You just lose confidence
and faith.
When you buy a mutual
fund or a stock, you're usually optimistic and hopeful, feeling
good about its prospects. But when that fund or stock doesn't
live up to your expectations, you can feel let down. Some people
tend to get this feeling at the first sign of trouble, while
others can seem to have abundant patience.
My experience tells
me that most investors seem to have an informal time frame of
one year for their expectations to be met or dashed. Cash flow
studies of mutual funds back up something I've noticed time after
time: What happens in the first year after somebody invests has
a huge influence on whether the investor will stick with it.
If the first year exceeds
and investor's expectations, that investor typically has tremendous
staying power through subsequent periods of disappointment. But
if the first year of an investment feels like a failure, many
investors will find it easy to abandon that investment later.
One year of pain is usually enough, it seems.
These reactions are
clearly emotional, almost as if an investment does or does nor
"deserve" one's loyalty and commitment. Most of us
know the value of loyalty and commitment. When you buy a car,
hire an employee, enter into a relationship, you are either in
the game or out of it. You aren't likely to be a successful employer
if you fire somebody, then hire her back, fire her again, then
beg her to come back, etc.
However, with investing,
it's possible to make a long-term commitment to something without
sticking with it through thick and thin. It's called market-timing.
You can be committed to an asset such as high-grade bonds or
small cap stocks and trade in and out of that asset through mechanical
timing.
I'm not going to tell
you that timing avoids disappointment, because it's a tough,
tough strategy to follow. But timing gives you a way to manage
your disappointment without abandoning an asset class that
in the long run should be productive for you.
An investor who uses
mechanical timing does not have to decide whether to stick with
an investment or sell it. The timing system handles that. But
the market timer has to either stick with or abandon the strategy
and the timing system. So all investors face essentially the
same issue.
These guidelines won't
completely do the job of answering our initial question"
When should an investor give up and pull the plug? But they will
point you in the right direction.
Before you make an
investment, make sure you have a plan for your overall portfolio.
It can be detailed or general, but you should know where a specific
investment fits. Your plan should have at least two essential
elements about which we have written extensively elsewhere: diversification
and some method to limit your risks.
Before you make an
investment, seriously consider the possibility that you could
lose money in it. Think about this enough that you won't be shocked
if you sustain a loss.
Before you make an
investment, figure out and write down why you are buying
this asset, what you hope from it and how much you are willing
to lose before you pull the plug. You could state this as a loss
of 10 percent or 20 percent, whatever you are willing to tolerate.
Before you make the
investment, figure out and write down the amount of time
you are willing to let this investment languish, if that's what
it does. If you buy an aggressive equity fund hoping for returns
of 20 percent or more per year, it's quite possible the fund
will subsequently turn in so-so performance that doesn't qualify
it for the doghouse but that doesn't meet your expectations,
either. Figure out how long you're willing to wait.
After you make the
investment, stick to your plans.
When you start to sense
serious trouble with an investment, see if you can figure out
why it's happening. Compare your investment to its peers when
you're trying to figure out whether to keep it. Don't expect
an emerging markets fund to behave the same way as Fidelity Magellan,
for instance. Before you conclude that your fund manager is incompetent,
find out how similar funds are faring.
Remember that your
emotions are more likely to make you err on the side of too little
patience than too much patience. If you're in doubt, give it
a little more time. On the other hand, don't stubbornly hang
onto a losing investment while you wait for it to "come
back" to the price you paid for it. Once you have truly
lost faith in an investment, you'll probably do better (emotionally,
if not financially) taking your loss and doing something else.
Honor the venerable
Wall Street advice: Cut your losses and let your profits run.
But at the same time, if you have made unexpectedly large gains
in an investment, take some of the profits to use elsewhere either
inside or outside of your portfolio. Inside the portfolio, use
some of those profits to rebalance. Outside the portfolio, use
some of those profits to do something nice for yourself and your
family.
I can't promise that
these guidelines will make disappointments easy to handle. They
won't make frustration fun. They won't turn losing investments
into profitable ones.
But I can promise that
if you follow them and adapt them to your own needs and personality,
you'll be a better investor. And that's certainly worth something.
Editor's Note: Paul
Merriman is founder and president of Merriman Capital Management.
He is also publisher of FundAdvice.com, 1 year, 12
issues, $125. Mr. Merriman is considered one of the
nation's top experts on mutual funds and manages over $240 million
for his clients.
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