Downside volatility returned to the markets this week, as unrest in Libya (and Bahrain, Yemen, etc.) caused oil prices to hit $100 in the U.S. for the first time in two years. The result was a notable daily drop in stock prices. The S&P 500 posted its fifth daily move of 1% or more since December 3 on Tuesday.
Ironically, the drop occurred the same day I read two research reports that discussed the possibility of a market correction. In addition, over the weekend, I noticed that the valuations of the stocks identified by my personal screen were not as cheap as they were a few months ago. (The screen is based on the 10-point stock scoring system presented in my book, Better Good than Lucky, and was detailed in the December AAII Journal.) However, both the reports and the screen results were coincidental with this week’s decline.
I cannot tell you whether we are on the verge of a near-term pullback in stock prices with any more accuracy than I can tell you which college basketball teams will make it to this year’s Final Four. I can tell you, however, that even the strongest of bull markets experience short-term declines (making any forthcoming pullback a normal event), and that my Kansas Jayhawks have the potential for a big run in the NCAA tournament.
Clearly there are risks if oil prices continue rising. However, over the long term, stocks compensate you for putting up with shorter-term volatility. There are always crevices on the proverbial wall of worry that stocks often climb. That does not mean you should keep one finger hovering over the sell button, however. Quite the opposite;you should be ready to leave your diversified portfolio unchanged while maintaining a plan for dealing with unwanted events.
An effective strategy for keeping your emotions out of your investing decisions is to write down the reasons you would sell an investment before you buy it. You will have the least amount of emotional attachment to a stock (or a bond, ETF, mutual fund, etc.) before you own it and will be most cognizant of its potential risks. You won’t be able to identify everything that could possibly go wrong, but you should have enough knowledge about an investment’s risks to give yourself a pretty good game plan.
I use a spiral notebook to do this. You could use whatever medium works best for you—a pad of paper, a smart phone, a PC, etc. It does not matter; your goal is to get the reasons for selling out of your head and onto something permanent. Doing so will give you a rational strategy you can depend on when the market gets volatile. Plus, you are not depending on your memory to determine what your sell strategy is.
Just knowing you have an exit plan can provide a boost of confidence when you need it. A plan for selling can also keep you from making reactionary market timing decisions, thereby allowing you stay focused on your long-term goals. As much as possible, you want to be a proactive investor, not a reactive investor.
You can’t predict the future, but you can have a strategy for dealing with uncertainty.
Rules for Selling
The most basic rule of stock investing is to sell when the reason you bought the stock no longer applies. This can mean the valuation has gone from low to high, business conditions have deteriorated, growth is slowing, or that a company’s strategy has failed to positively adapt to a changing marketplace. I personally also look out for downward revisions to earnings estimates and negative news events, as well as relying on price targets to force me to reevaluate my investments.
Though there are underlying commonalities, rules for selling differ depending on the type of investing style. Regardless, always have a plan ready in case markets get to volatile.
Charles Rotblut, CFA, is a Vice President with the American Association of Individual Investors. His new book is Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio.
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