Knowing when to fold 'em

On Mondays, we post a question and a response relating to finances. This week, we’re tackling a question that a great number of investors are pondering.

How do you know when it is time to divest of a particular stock or mutual fund and put your money in something else?

Make a change when something else offers genuinely better prospects. That's not an easy thing to know, especially for an amateur. With some 25,000 mutual funds or share classes, there is always something that might look better at a single point in time. People always flock to "safe" investments in a bear market, because they look good against the alternatives. But that's the wrong choice. The critical question isn't what looks better right now. The critical question is what looks better going forward. And Treasury Bills or bank certificates never compare better as we look forward for five or 10 years.
Others throw money at the hottest stocks or funds, as featured on the cover of Money magazine or other similar publications, but that rarely works, either. In truth, a fund or stock is called hot because it's recent performance is good. The best time to buy something is before it becomes hot. This is also true of much historical performance. Things always look good after they've done well. Research shows that there is little evidence that past performance indicates much about the future (language the Securities and Exchange Commission requires in prospectus documents). Even the best funds in the world suffer occasional bad years. Is that necessarily a reason to change?
Everyone hates taking losses, but that's a bad reason to hold on to something. If you always take profits on your good things, and hold onto the bad to avoid losses, eventually you'll have an entire portfolio of bad investments. Focus on the future, not the past. Keep or buy things with good prospects, and dump the ones without. Take your losses like a grown-up, and move on.
Remember , too, that much investment news we encounter was crafted by public relations or sales professionals. So those great ideas we see were usually planted by someone. I've always rejected the notion that individual investors - including the typical stockbroker - can "out-think" the pros at Fidelity or Vanguard or American Century, with their legions of analysts. Did you know that 80 percent of trades on the NYSE are placed by institutional investors? That means that when you buy or sell something, the trade's other side is taken by a professional. Let that sink in for a minute. This is one of the best arguments for using mutual funds, and why so many professional advisors choose that approach.
This is another reason why we use Morningstar or other independent research firms in building client portfolios. We take responsibility for our decisions, and work on behalf of our clients. No one is going to "talk us into" making a trade or exchanging one investment for another. We'll make those decisions when, and only when, they make sense for clients. It's a huge benefit.
Got a question for us? Post it in the comments or DM us on Twitter @family_finances. We always love to hear from our readers.