Investing can really mess with your head. In fact, there's a branch of psychology called behavioural finance that helps explain stock market anomalies. Study after study has failed to explain exactly why we do what we do, but it basically comes down to two contrasting emotions: fear and greed.
Greed is what got the world into this financial mess with the misguided belief that we could keep borrowing and markets would always go up. Now, with many investments trading lower than pre-meltdown levels, fear is firmly at the wheel. But fear shouldn't allow us to compound our losses when markets take a dip. Here are 3 things to think about before selling an investment.
Buy low, sell high
Obey the most basic rule of investing: A stock that is trading higher than your original purchase price is always a selling opportunity. When to sell is up to you.
Stocks that are trading below the purchase price are another story. Our fear instinct makes us feel the pain of loss and strive to avoid future pain — so we might be irrationally inclined to sell at a loss.
Before hitting the sell button ask yourself why you bought the stock in the first place. If it was a good company with solid earnings and growth potential at $5, why isn't it a good stock at $3?
Next, look at why the stock went down. Was it something specific to that company or was it unfairly punished by a broader market selloff? If it was, how did it weather the drop compared with other stocks in the same sector?
Seasoned value investors like Warren Buffett often look at a broad market selloff as an opportunity to buy more. They figure if the company was a good buy at $5, it's an even better buy at $3.
Income is income
If you bought a stock for its strong, consistent dividend yield why worry about its day-to-day price? Dividends are paid out on a per-share basis and the number of shares an investor owns does not change with the stock price.
Dividends are derived from a company's earnings which are derived from sales. To determine whether a dividend is in jeopardy go to the company's website and search the latest financial statements for inconsistencies in earnings and revenues.
If you're looking for a silver lining to a falling stock, many issuing companies offer dividend reinvestment plans (DRIPs) that automatically use dividend payouts to buy more shares in the company. If the stock price is down, the payouts will purchase more shares at a lower price.
Don't make other people rich
A market loss is a paper loss. When you sell, it's a real loss. That rule is compounded by trading fees and possibly taxes — also known as frictional costs.
Tweedy, Browne Company, one of the most respected investment firms in the world, conducted a study that shows a buy-and-hold strategy could result in returns as much as 150 per cent higher than a portfolio with a high turnover rate. In other words, heavy trading could eat into returns.
When markets are volatile in either direction trading volumes increase. When trading volumes increase, commissions increase and brokers get rich.
A stock that is sold at a loss could be used to offset any capital gains, which supports an argument to sell. But a stock sold for gain will trigger a capital gains tax, which also eats into returns.
Emotions can kill profits and one way to help take the emotion out of investing is to run it by an investment advisor for a sober second thought.