4 Questions To Ask Before You Sell Your Stocks

| About: DFA U.S. (DFSVX)
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Summary

Do you think falling prices today is good news or bad news for tomorrow's returns?

If you get out of stocks, when will you get back in? And can you afford the return on stock alternatives while you wait?

Have you studied previous periods of market turmoil to see how stocks have responded? Why do you think this time will be different?

Stock markets around the world have fallen sharply since Friday after the UK voted to leave the European Union. During times like this, investors who don't have a plan that outlines how they will achieve their long-term goals are especially susceptible to making panic-driven decisions to sell. But even those who do have a plan often wonder if sidestepping some of this volatility and waiting for a better time to invest might be prudent. Regardless of which camp you are in, here are four questions you should ask yourself before you sell your stocks:

#1 - Did You Know Lower Prices = Higher Expected Returns?

Investors assume when stock prices have fallen, future returns will be lower. But that's not quite right. All things being equal, lower prices today mean higher expected future returns. Ask yourself this - did you earn higher returns on your S&P 500 fund (VFINX/VFIAX/SPY) from October 2007's prices, or October 2008's, after a 40% decline? I've embedded the answers in each year's hyperlink so you can look for yourself. Higher returns don't materialize because stocks always reverse course immediately after a big decline. It's because, when they eventually do, the gains more than make up for the losses. And typically, the larger the losses, the more significant the recovery (because expected returns continue to go up as prices decline).

More specifically, the stock market has to provide you the expectation of a higher return on your investment compared to safer alternatives - bonds, savings accounts and CDs. If this weren't the case, no one would buy stocks and accept their volatility. So why do prices go down? When our expectations of the future change for the worse, prices have to fall so that achieving that future value (or even a value slightly lower) implies an even higher return (for a future value of $100, let's say, a purchase price of $40 yields a higher return than $50; even if the future value will only be $90, $40 still provides you with a higher return). The contrary is also true, when expectations rise, so do prices, and our returns between now and then will be successively lower. In that way, market prices fluctuate so that at any point in time, an investment in stocks is expected to yield an acceptable return even considering the relative certainty or uncertainty about the future.

For existing investors, you've already experienced the price declines that have brought about higher future expected returns. Why wouldn't you stick around to experience them?

#2 - If You Get Out, How Will You Know When To Get Back In?

The reality of investing today is that most investors cannot achieve their long-term goals, which require some return in excess of inflation, by holding only "safe" assets like bonds, savings accounts and CDs. So getting out of stocks is not a permanent option, only a temporary one. But how will you know when to get back in?

I often hear investors say "when things improve," or "when there's more certainty." But this never works. By the time it's comfortable to invest, stock prices are typically much higher than when you got out. Consider the best time to get back into the market after the 2008 decline - March 9th, 2009. What was the headline of the day? Warren Buffett told CNBC that the economy had "fallen off a cliff." Now that's scary. How about a year later? Smart Money was running a story asking if the recovery was just a giant illusion? You'll never get an "all clear" sign to re-enter the market. Remember what Rob Arnott said about investing: "what's profitable is rarely comfortable."

#3 - Can You Afford To Get Less Than The Stock Market Return?

One of the great mistakes that most investors make is to not hold enough in stocks. With a five-year Treasury Note only yielding 1.2% and a five-year Treasury Inflation Protected Bond yielding -0.3% (which doesn't include inflation credits), you can obviously see that a bond-heavy portfolio is all but guaranteed to underachieve relative to even modest return goals.

But even those investors with growth-oriented portfolios including healthy commitments to stocks don't do themselves any favors. In a study conducted by Vanguard founder John Bogle (page 113, "Clash of Cultures"), he found that investors only earned +4.3% per year on their stock funds over the 15-year period from 1997 through 2011 compared to a return of +6.5% on the funds themselves. That's not a typo, investors tended to buy and sell at the wrong time, chasing hot performance, but also panicking during market declines, shifting their funds from recent underperformers to those funds that had outperformed, only to see the cycle play out again in reverse. They lost over 2% per year of their returns to poor decisions.

In my experience, episodes like Brexit, the euro debt crisis from 2011 and the Lehman bankruptcy in 2008 are the primary causes of this bad behavior most investors are guilty of. Just a few poorly-timed decisions (which, at the time, seem entirely logical) can subtract several percentage points from your long-term annual returns. Can you really afford to earn less on your stocks in an era when asset class returns are already depressed?

#4 - Do You Know How Markets Have Responded To Adversity?

Chances are, regardless of how long you have been investing, that you don't remember all the historical episodes of economic and financial turmoil in your life. Our brains are hard wired to forget or minimize the memory of past traumas that we've experienced. As investors, this causes us to believe every crisis we live through is much worse than anything we've seen before. But a short history lesson will remind you that, while each situation is different, financial crises are a normal aspect of investing and that markets have been very resilient in the face of adversity.

Market Shock

Stocks - Next 12 Months

Stocks - Next 3 Years

Stocks - Next 5 Years

Asian Financial Crisis (September 1998)

+24.9%

+23.4%

+53.0%

World Trade Center Attacks (September 2001)

-7.1%

+55.4%

+120.3%

Lehman Bankruptcy (September 2008)

-2.7%

+0.4%

+63.3%

U.S. Debt Downgrade (August 2011)

+9.7%

+70.6%

+65.8%

Boston Marathon Bombing (April 2013)

+23.3%

+25.7%

- - - -

AVERAGE

+9.6%

+35.1%

+75.6%

The chart above lists five market shocks that we have experienced in the last 20 years and the subsequent return on a diversified stock asset class portfolio (see footnotes for specific allocation) over the following 12 months, three years and five years.

Much of the time stocks were materially higher just a year later. Even including the two negative years following the World Trade Center Attacks and the Lehman Bankruptcy, stocks gained about 10%, similar to the long-term average in all years. Three years later, stocks tended to be significantly higher, and each five-year period eventually experienced a strong bull market.

One other consideration - some investors don't sell out completely during times of financial trauma, but give in to the urge to tweak their portfolios. Counseled to "re-evaluate their risk tolerance" by some advisors and the financial media, many investors only sell some of their stocks in the name of "prudent asset allocation." But let's be honest, this is just panic selling in a different and milder form. And it will still probably cost you dearly. There wasn't a single five-year period in the examples above where stocks subsequently underperformed high-quality, short-term bonds. On average, the stock mix produced a return of 52% more over these periods. Abandoning your plan and changing your asset allocation by even just a small amount could have serious consequences for the long-term growth of your wealth.

After reading these thoughts, you certainly know where my opinions lie and what I've been counseling our clients to do (or not do) during this period of market volatility. I've talked to countless investors over the years who have seen hard work and significant savings ravaged by poor financial decisions - acting on emotion instead of according to a plan. I only hope that you take these considerations to heart and that they help you to avoid making the same poor decisions, not only today, but also in future crises as well.

Finally, I would be remiss if did not point out that if you are an individual investor having a difficult time acting on logic and sensibility, instead of falling victim to panic and fear, it might be time to partner with an independent, fiduciary-minded financial advisor who can help to bring some structure and rationality to your investment experience. It might wind up saving you a considerable amount of your wealth in the long run.

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Source of data: DFA Returns Web

Diversified Stock Asset Class Portfolio = 21% DFA U.S. Large Company Portfolio Inst (MUTF:DFUSX), 21% DFA U.S. Large Value Portfolio Inst (MUTF:DFLVX), 28% DFA U.S. Small Cap Value Portfolio Inst (MUTF:DFSVX), 18% DFA International Value Portfolio Inst (MUTF:DFIVX), and 12% DFA International Small Cap Value Portfolio Inst (MUTF:DISVX). Rebalanced annually on December 31st.

Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX.

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.