Wednesday, April 14, 2010
Know when to hold 'em
We answer questions here from followers of our Twitter feed, @family_finances. If you have a question, please post it in the comments section or e-mail it to email@example.com.
QUESTION: On the NPR radio program Marketplace Money last Sunday, the financial experts were discussing setting a target for when to sell an investment, such as if it drops 10 percent in value, or if it rises 10 percent in value, so that investors don’t hold on to an investment too long. If you’d like to do that, what percentage would you suggest? And should the percentage be the same for an investment that’s dropping as one that’s rising?
ANSWER FROM DAN DANFORD: This really depends on the kind of investing you do. If you own individual stocks, then having some targets is helpful. Generally, you want to buy stocks when the price is low, and sell when it's high. A stock is actually a portion of a company, and the value is determined by financial things like revenues, assets, and profitability. But different people have different estimates of those numbers, so two informed people can have different estimates of value.
An analogy I sometime use is a house. We can both visit a house and agree that it is a spectacular house. We'll agree on the square footage and building materials and the size and quality of the lot. We can gather information on other, similar houses, and even the level of mortgage rates. But, still, we can reach different conclusions on the house's value. Even if we agree on the exact value, we might argue over a smart purchase price. Let's pretend for a second that the house is "worth" $200,000. Would you pay $300,000 for it? How about $225,000? If you could grab it for $150,000, would you?
Stocks are kind of like that, too. Just because a company is good (or even great) doesn't mean the stock is a smart buy at a particular price. The true value is a moving target, and sometimes the stock will sell for less than value. Other times, it's selling for more. A good stock picker will buy when the price is lower than estimated value, and sell when higher. That sounds easy enough, but it's harder than it sounds.
Now, the idea behind price targets brings some structure to the process. You estimate value, then create a band around that price. When the stock moves one way or the other, you take action. If you were wrong in estimating value, a low target will reduce your risk. You can limit your losses by deciding where to sell before you even buy. On the other hand, a high price target forces you to take profits when they occur. Perhaps this takes some of the emotion out of decision-making.
Having said all this, I'm not a big advocate of picking individual stocks. It takes an incredible amount of time and most people can't do it well enough to beat the markets anyway. For most folks, a low-cost index fund will produce better results with less effort. Diversification also reduces risk, and funds do that better than any other option. We use funds in managing million-dollar portfolios, and that's probably the best approach for your IRA or investment account, too.
The best thing that can be said about pricing targets is that they require some forethought about your investments. Too many investors buy the hottest stock or fund without enough thought about the overall strategy or purpose. People focus on the trees, instead of the forest. I'm for anything that brings thoughtful deliberation to investing.