5 Questions to Ask Yourself Before Hitting the 'Sell' Button

Jason Stipp: I'm Jason Stipp for Morningstar. Markets have been up and down in recent days, but mostly down, which means a lot of people have selling on the mind. But before you run for the exits, Morningstar's Christine Benz, our director of personal finance, says you should ask yourself these five questions.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: We know that a lot of people are selling in the market today. We can see it, but you say before you hit the "sell" button, you should stop and think about five key things, because it could keep you from potentially making a mistake. The first one is, before I sell a particular investment, I should ask myself, would I have sold this about a month ago, in December?

Benz: In December, the market was performing a little bit better. The value of asking that question is that it can help you sort out whether you are inclined to sell because you don't like the losses that you've had recently, you are worried about performance. Or are you inclined to sell for some more fundamental reason?

If you have an investment that you've been worried about for some time--maybe it's an individual equity that, even after the recent market volatility, still looks overvalued to you or is too large a position in your portfolio. Those are good, fundamentally based reasons to sell that are distinct from the recent downturn. Maybe the downturn has just accentuated your motivation to sell it.

If you're a fund investor primarily and you've got holdings that were taking up too large a share of your portfolio, and they still are, or maybe you've determined that they are simply too risky for you, that you just are not comfortable with this type of volatility. I think those are perfectly good fundamentally-oriented reasons to sell. And it might make sense to unload those positions, even though the market is trending down and you often hear that you shouldn't be a seller in a market downdraft.

Stipp: Another question you might ask yourself is, have my long-term plans changed, which might mean I might need to make some changes in my portfolio?

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Benz: For example, if you are someone who is getting close to retirement and the asset allocation framework that you are using has changed, and it calls for having a greater allocation to bonds and perhaps even cash to queue up money for living expenses. In that case, even though it's not usually a great idea to be selling equities during a downdraft, it is perfectly defensible to consider getting your portfolio in line with your target allocation. You may want to do it over a period of months rather than all right now, but it's certainly not unreasonable to undertake that sort of reallocation in this type of market environment.

By the same token, some investors' plans might not have changed, but their portfolio may have changed. If they've done nothing to their portfolios, chances are their equity allocation has generally drifted up over the past several years. In that case, too, getting that portfolio back in line with the target allocations makes a lot of sense.

Stipp: Another thing that investors in taxable accounts need to think about is, what are the tax implications of the sale going to be? It's not something that should always lead your investment decision-making, but you shouldn't forget about taxes, either.

Benz: If you're looking at some investments and you don't like the fundamentals or you have some other reason to consider selling, definitely take a look at the tax consequences of selling that position. For some investors, if they've had a holding for a period of years--we have been in a fairly strong equity market--it's a good bet they actually would trigger a capital gain to get out of that position. You want to factor that into your decision-making. You want to make sure that the money you are saving by unloading it will offset the capital gains that you are unleashing. So keep that in mind.

If, on the other hand, you actually have a loss in a holding over your holding period, that might accentuate the value of selling now. The value of realizing losses is that you can use them to offset capital gains. You can also use them to offset up to $3,000 in ordinary income. So if a tax loss lines up with some fundamental or portfolio-based reason for unloading a security, that can burnish the idea of selling.

Stipp: Here is another good one to ask yourself before a sale: You should say to yourself, if I sell this now, how will I know when to get back in?

Benz: This is particularly appropriate for investors. I do not advice this, but some investors do engage in an element of market-timing, where in periods of extreme volatility they might pull back their equity weighting substantially. They might get out of equities altogether. And that certainly holds some psychological appeal. It might feel good on the days when everything is sinking, and you know that you don't have any equity exposure.

The real problem with this strategy appears when markets begin to ascend. When the market turns around, it tends to turn around in a hurry. We tend to see the bulk of gains come on just a handful of days. So that person who has greatly reduced exposure to a given asset class or a given market sector is left with that gnawing feeling: Is it time now, or is this just a head fake? It's generally not advisable to do a lot of jockeying around among asset classes, because you're left with this gnawing feeling about whether it's time to get back in.

Anecdotally, when we look across the tactical fund universe--we follow fund managers who use very active asset allocation strategies--one thing we see is that while they do tend to protect on the downside, many of them tend to underperform on the upside. That's the conundrum that a lot of overly tactical or market-timing individual investors can find themselves in.

Stipp: I remember in 2009-2010, there was so much handwringing about, is the market going to double dip? Nobody ever really knew when it was ready to shoot up. And if you miss those days, you missed a lot of the gains coming out of 2008.

Benz: That's right.

Stipp: The last thing you should ask yourself before you make a sale is, what am I going to learn from this experience so I can be a better investor in the future and make sure that I'm making the right decisions?

Benz: A fund shop that Morningstar has long followed and admired has what they call a "Wall of Shame" for positions that didn't work out, where the managers think about what they got wrong, what they can learn from the experience. That's not to say that everything investors might be selling today are definitely mistakes, but it's certainly worthwhile to take a look and see if you've made any miscalculations. See if you can improve your future performance through this experience.

Maybe the investment that you want to sell was a holding that you purchased that has simply been too risky for you; it's been giving you a lot of sleepless nights. Take that to heart when you think about positioning your portfolio in the future. Maybe it was a position that you were allowing to take up too large a share of your portfolio; you didn't trim it back preemptively. There are definitely takeaways for investors who decide to sell. I think some of these volatile market environments can be the most instructional for us as investors in terms of improving our future performance.

Stipp: Christine, some very good considerations all investors should take into account before making a sale. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.