In the fall of 1976, I sat in the Investments class of Dr. David Rankin at Southern Arkansas University.
Dr. Rankin told the parable of a man who bought a stock at $10 and then steadily watched it climb to $20, $30, $40 and onward all the way to $100. As he watched the stock climb, he became more and more excited and held on to all the shares. Once the stock hit $100, however, it began dropping in price. At $90, he told himself why sell any, since only a short time back it was worth $100. However, the stock continued dropping to $80, $70, $60 and eventually back down to $10. Frustrated, the man sells out at $10. He was heard to remark, “Well, at least I didn’t lose any money!”
At first glance, his conclusion may appear correct. He bought in at $10 and sold at $10, realizing a break-even position. No gain, no loss! But is that really the case? Assume he bought 100 shares at $10, for a total investment of $1,000. Once the stock reached $20, his investment is worth $2,000. Suppose at that point, having doubled his money, he sells 20 shares at $20, recouping $400 of his investment. He still holds 80 shares worth $1,600. The stock then continues to climb. At $30, assume he sells another 20 shares, netting $600 in cash. He now has recouped $1,000 in cash and still has 60 shares worth $1,800. To simplify the example, assume he takes no further action until the stock again drops back to $10. He then sells the 60 shares for $600. In this case, by harvesting some gains, his total revenue is $1,600, for a gain on his investment of 60%! If he had continued harvesting additional shares as the price rose, his gain would have been even greater.
Investors often take an “all or none” approach to an investment. Assume Walmart is trading at $130. Your cousin’s neighbor’s brother-in-law works at Walmart and heard a rumor in the breakroom that it’s going to $180 a share. Based on this “credible” information, you buy 100 shares at $130. You’re fixated on that $180 price and may be hesitant to take action until it hits that price. But if Walmart hits $155, you’ve got a nice profit of $25 a share and it might make sense to take some money off the table by selling a portion.
Assume at $155, you sell 25 shares, one fourth of your position. Walmart then moves to $165 a share. If you had sold all 100 shares, you would have seller’s remorse. Instead, you still have three fourths of the stock now trading $10 higher than previously. What if, instead of Walmart moving to $165, it dropped to $145? You unloaded a fourth of your position at $155, collecting some cash and reducing your exposure.
The same concept applies to mutual funds. Suppose you buy $1,000 of mutual funds, $500 in a bond fund and $500 in a stock fund. You are comfortable with a 50-50 mix of stocks and bonds. Over time, the stock fund rises to $700 and the bond fund is flat at $500. If you sell $100 of the stock fund and reinvest it back into the bond fund, you are still at a 50-50 mix, the same level of stock market exposure as before. You’ve also sold at relatively higher prices for stocks. You’ve put into practice that old adage, “buy low and sell high.”
You might be concerned about the cost of making multiple trades. Many trading platforms such as Schwab and Fidelity now allow for no-fee trades. Even if your custodian doesn’t offer free trades, the trade charge will be minimal. So the cost of making incremental trades is not a factor. Get past that “all or none” mentality of trading and you stand a good chance of increasing your overall returns.
Dr. David Ashby is a Certified Financial Planner and the retired Peoples Bank Professor of Finance at Southern Arkansas University. He holds degrees in accounting and business administration and a doctorate in finance from Louisiana Tech.