AAII Investor Update: The Opportunity Cost of Not Selling

Imagine that somebody came at night and sold everything you own. Then ask yourself, would you repurchase the same things?

This is an exercise Dan Ariely suggested in a conversation he and I had earlier this week. Ariely, a professor of psychology and behavioral economics at Duke University, has used this exercise to show how individuals often become attached to and find it hard to part with their belongings.

It happened to be a timely suggestion as I spoke with two other people this week about the opportunity cost of holding onto troubled stocks. Opportunity cost is the reward lost by not allocating your resources elsewhere. In terms of investing, opportunity cost is the higher return you lose by not switching to a better stock, bond or fund.

It is not uncommon to struggle with inertia when faced with an investment that should be sold. Nobody likes admitting they made a mistake. Bad news is often viewed as a temporary occurrence. A security’s past performance or expectations that a rebound is just around the corner are commonly used as justifications to continue holding onto an investment. At worst, a short-term trade turns into a long-term investment as an investor holds out hope that it is just a paper loss and that if they wait, the stock price will make a comeback.

The inherent problem is that such reasoning doesn’t factor in how much could be made if the money were invested elsewhere. Seeing an investment recoup its loss may be emotionally satisfying, but it may not make economic sense if alternative investments rise by an even greater amount over the same time period.

This does not mean you should be quick to sell. Selling too often results in unnecessary transaction costs (including potential tax expenses) that can also hurt your portfolio performance. Rather, you should have a strategy in place for evaluating your investments in a rational manner.

I personally believe one of the best things an investor can do is to write down the reasons they would sell an investment before they buy it. An investor is more likely to be objective before he clicks on the buy button. At the most basic level, an investment should be sold when the characteristics that made the stock, bond or fund attractive in the first place no longer apply. An example would be a company that previously grew earnings, but is now seeing a trend of declining profits.

Keep in mind that the decision to sell will not always be clear cut. It is not unusual for an investment to violate the spirit of your buy strategy, but not quite stink up the place. Many times, you will have to make a judgment call. In such situations, ask yourself, if you didn’t own the stock already, would you buy it now? If the answer is no, consider an alternative.

Just be careful not to second-guess yourself too much. Though there are opportunity costs to not selling, selling too frequently may cause you to miss out on opportunities for upside returns as well. As far as my conversation with Dan, I intend to publish the interview in an upcoming issue of the AAII Journal.

More on AAII.com

• How to Take Your Emotions Out of the Sell Decision – Fund manager Jim Norris offers tips on how to be more objective about selling in this 2002 AAII Journal article.
• 5 Memorable Mistakes and the Lessons I Learned – In searching AAII for articles about investor behavior, I found this interesting article written by fund manager John Deysher. It gives great advice and shows that even pros make investments they wish they hadn’t.
• New! May 2012 AAII Journal – The May AAII Journal features articles about municipal bonds, how to analyze a balance sheet, momentum trading and more.
• How quick or slow are you to sell? – Tell us on the AAII Discussion Boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

Two Dow components will report earnings next week: Walt Disney (DIS) on Tuesday and Cisco Systems (CSCO) on Wednesday. Joining them will be nearly 30 fellow S&P 500 members.

We won’t see the first economic report until Wednesday, when March wholesale trade data will be published. Thursday will feature March international trade and April import and export prices. The April producer price index (PPI) and the preliminary University of Michigan consumer sentiment survey will be published on Friday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday, and $16 billion of 30-year bonds on Thursday.

AAII’s Joe Lan will speak to our Columbus, Ohio, chapter on May 16, 2012. We have chapters and groups across the country, so be sure to check out the AAII Local Chapters page for information on upcoming meetings near you.

AAII Sentiment Survey

Neutral sentiment reached a six-month high in the latest AAII Sentiment survey. Bullish sentiment rose, while bearish sentiment fell.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded 7.8 percentage points to 35.4%. This is the highest level of optimism in a month. Nonetheless, bullish sentiment remained below its historical average of 39% for the fifth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.2 percentage points to 36.1%. This is the highest neutral sentiment has been since December 22, 2011. It is also the fifth time in six weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 8.9 percentage points to 28.5%. This is a four-week low for pessimism. It is also the first time in four weeks that bearish sentiment has been below its historical average of 30%.

A recent rebound in stock prices following the recent dip and mixed economic data are combining to keep neutral sentiment at above-average levels. Better-than-expected first-quarter profits, signs of continued economic growth and a return of some upside volatility in stock prices are helping optimism. Conversely, volatile market conditions, concerns about the pace of domestic economic growth, high gasoline prices, and the ongoing European sovereign debt crisis are keeping many individual investors pessimistic.

This week's special question asked AAII members if they thought prospects for the U.S. economy have improved over the past few months. The responses were evenly split. Among those who thought conditions have not improved, Europe's sovereign debt crisis was frequently mentioned as an ongoing threat. Others said economic conditions, including inflation, were worse than the data suggests. Among those who thought the economy is getting better, improvements in the economic data and the markets were cited. Respondents in both groups said they were keeping an eye on events in Congress and on the outcome of the upcoming presidential election.

Here is a sampling of the responses:

• “We’re still in slow growth mode. Housing is still in the doldrums, and the slowdown in Europe doesn’t help.”
• “I think the European economy will drag down the U.S. economy in the next three to six months, regardless of what the Fed does.”
• “I fail to discern any fundamental changes one way or the other. If anything, the potential for adverse occurrences has marginally increased.”
• “Prospects are much improved. The economic data is showing a slow, but steady recovery.”
• “The core economy is improving as people get back to work and demand improves.”
• “The mall is full of people.”

» Take the sentiment survey

AAII Asset Allocation Survey

Though individual investors made only minor revisions to their portfolios, cash allocations rose to a four-month high according to the April AAII Asset Allocation Survey.

Stock and stock fund allocations were 60.6%, a decline of 0.1 percentage points from March. This was the third consecutive month in the last four that equity allocations were above their historical average of 60%.

Bond and bond fund allocations were 18.8%, a decline of 0.2 percentage points from March. This was the first time since October 2011 that fixed-income allocations were below 20% for two consecutive months. Nonetheless, bond and bond fund allocations were above their historical average of 16% for the 34th consecutive month.

Cash allocations rose 0.3 percentage points to 20.7%. This is the highest allocation to cash since December 2011. It is also, however, the fifth consecutive month that cash allocations have been below their historical average of 24%.

Though AAII members became more pessimistic about the short-term outlook for stock prices in April, they largely left their portfolio allocations unchanged. Stocks have had a strong start this year, though worries about the pace of U.S. economic growth and global sovereign debt are keeping equity allocations close to their historical average. At the same time, many individual investors are using capital preservation strategies for a portion of their portfolios even as they remain frustrated with the low yields offered by bonds and money market accounts.

This week’s special question asked AAII members what changes they have made to their portfolios in response to the first-quarter’s rally in stocks. The largest number of respondents said they have not made any changes or they thay have only made what they described as minor changes. One smaller group of respondents said they sold stocks and raised their cash allocation, while another small group said they bought stocks. (Slightly more said they sold stocks than said they bought stocks.) Several respondents said they rebalanced, bought high-quality dividend-paying stocks or were monitoring their portfolio more closely.

Here is a sampling of the responses:

• “I do not make changes based on short-term rallies.”
• “I rebalanced back to my target percentages, selling some stocks and buying intermediate-term bond funds.”
• “No changes. I am well diversified and rebalance any time I am more than 5% off my allocation. I am not a market timer.”
• “I’ve only made small transactions. Overall, the portfolio is about the same.”
• “I added several blue-chip, dividend-paying stocks.”
• “I have begun to take profits and adjust my stop limits upward since I’m expecting a correction between now and June.”

» Take the Asset Allocation Survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor