Should You Sell Your Stocks In A Market Sell-Off?

| About: SPDR S&P (SPY)

Summary

As the year started with a strong correction, many investors were tempted to sell some of their stocks, hoping to repurchase them at lower levels.

In this article, I analyze why investors should not indulge to this temptation.

Market timing is much harder than most investors think for many reasons.

The year started on a remarkably bearish tone for the markets, with January incurring its worst losses ever. While the markets retrieved part of their losses this week, they are still in red territory for the year. For instance, S&P (NYSEARCA:SPY) is down 6% so far this year. As the sentiment is still negative and the duration of this bull market has stretched far beyond the average, it is only natural that investors are tempted to sell some of their stocks temporarily to avoid the pain of the sell-off, hoping to reestablish their positions at significantly lower levels. However, in this article I will analyze why investors should not indulge to this temptation.

First of all, it is almost impossible to time the market. Studies have shown that investors who try to time the market are wrong most of the time. This is due to human nature, which exerts psychological pressure to investors to sell when the sentiment is the worst and buy when everything seems rosy. As we know, the sentiment is always extremely negative near bottoms and overly positive near tops. Therefore, most investors, who make decisions based on their feelings and the surrounding market sentiment, are condemned to make the wrong decision most of the time.

It is also remarkable that 6 of the 10 best days of the market occur within two weeks of the worst 10 days. It has been shown that a portfolio invested in S&P in the last 20 years would increase from $10,000 to $65,000 during that time frame. However, if investors missed the best 10 days of the market, their portfolio would rise only to $32,665 during the same time frame. Therefore, it is critical that investors do not miss the best days of the market, as they greatly affect the long-term performance of a portfolio. Even worse for market timers, the best days occur shortly after the worst days and hence one essentially needs to be a prophet to miss the worst days without missing the best days.

It is also worth noting that even the legendary investors Warren Buffett and Peter Lynch have admitted that they cannot time the market and hence they do not try to. For instance, Buffett initiated a significant stake in Exxon Mobil (NYSE:XOM) just before the worst bear market of oil got started. Thus he sold his stake only a quarter later. Buffett and Lynch have repeated several times that they just look for attractively valued stocks that have ample room for future growth. Whenever they find such stocks, they never try to predict where the interest rates are heading or whether a major correction is imminent for the markets. They just buy these stocks and completely ignore the short-term gyrations of the market.

Even those who are considered to have great predicting skills cannot time the market consistently. For instance, Nouriel Roubini is well known for predicting the Great Recession. However, he predicted it in 2005, just in the middle of the major bull market 2003-2007. Therefore, investors who took his advice missed at least half of that bull market. Even worse, Roubini predicted another collapse several times after the Great Recession but he was proven wrong in every single occasion. From all the above evidence, investors can safely conclude that it is almost impossible to time the market, certainly on a consistent basis.

Even if some investors possess this exceptional skill, it is equally difficult to determine the right time to reestablish a position that was closed for a better entry point. For instance, during the ferocious bear market of the Great Recession, Wal-Mart (NYSE:WMT) and McDonald's (NYSE:MCD) fell only 25% and 22%, respectively, from top to bottom, while the market fell about 55%. In addition, the market sentiment was extremely negative for months (actually for years) after the market bottomed and most investors thought it was just another "relief rally" of the bear market. Therefore, most investors who sold their stocks did not reestablish their positions at lower levels. They either missed a great portion of the strong bull market or they capitulated after several months of waiting and repurchased their stocks at much higher levels that their selling points. Unfortunately for them, selling low and buying high is not a profitable strategy.

Investors should also take the cost of waiting into account. More specifically, as soon as they sell their positions, they stop receiving quarterly dividends. This is a significant cost that is often forgotten by those who try to time the market. For instance, McDonald's kept paying an approximate 4% dividend during the Great Recession. Therefore, the stock paid about 6% to its shareholders during that bear market, which lasted one and a half year. Consequently, those who sold the stock missed a significant amount of income and would have to call almost the absolute top and bottom of the stock to profit from their market timing. Even worse, the commissions and fees of market timers would make the returns of their strategy even lower.

Finally, investors should realize that their long-term performance greatly depends on their commitment on a well-planned strategy. If they twist their strategy based on the short-term gyrations of the market, they are condemned to fail. This has been proven several times during the ongoing 7-year bull market, as every correction has proved short-lived so far. Some corrections, like the one in the summer of 2011, have been really steep and scary but those who sold their stocks were left out of the train or reentered the market at much worse levels.

To sum up, as timing the market consistently is impossible, investors should not sell their stocks in a market sell-off in order to avoid the pain of paper losses. Instead they should continuously monitor the business performance of their stocks and hold them as long as their business keeps thriving. In addition, a market sell-off is the most opportune time to purchase a new stock, one that has been on the watch list but has been avoided due to its rich valuation. As sell-offs are always steep, it is undoubtedly hard to keep watching the nominal value of a portfolio bleeding but only those who can easily tolerate this bleeding can achieve great long-term results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.