Portfolio Management | July 26, 2021

How to Make Rational Buy and Sell Decisions

Despite every intention of making rational, reasoned decisions—especially when it comes to our finances—we sometimes allow emotions to get the better of us.

Worse, we have a tendency to rationalize away any resulting missteps, which over time only compounds the initial error.

Nobel Prize-winning psychologist Daniel Kahneman has done extensive research into how we can make more deliberate and logical decisions when our emotions are running high. His conclusion? Slow down. The more time you take, Kahneman’s research suggests, the less likely your emotions will cloud your decision-making.

In practical terms, that means taking a beat and really thinking through why you want to buy an investment. Does the asset support your goals, or are you merely chasing a hot stock or market?

The same holds true when you want to sell. Does the investment no longer fit your strategy—or is fear driving your decision?

Here’s how to know whether you’re selling or buying stocks, bonds, and funds for the right reasons.

Stocks

“If you’re willing to buy or sell at any price, that’s a tipoff you’re not thinking rationally,” says Steve Greiner, managing director of Schwab Equity Ratings®.

To add more discipline to your investment decisions, study a stock’s fundamentals—including the price-to-earnings ratio, dividends and buybacks, and return on capital—and consider them in context.

When adding new positions to your portfolio:

  • Favor stocks with high levels of cash and low levels of debt, both of which suggest good financial health.
  • Be wary of stocks whose earnings growth seems excessively high, because they're likely unsustainable. Conversely, you should also be skeptical if a company has no earnings at all, especially if it’s in an industry that investors are piling into. “Those businesses are often living on borrowed capital,” Steve says.


When reviewing the stocks you already own:

  • Watch for deteriorating fundamentals, which often indicate trouble. “You should ditch a stock as soon as it fails to live up to your reasons for buying it in the first place,” Steve says. However, if the stock’s price is falling, but its fundamentals remain strong, it could be well-positioned for a rebound. “Don’t let fear trick you into parting ways with a worthy investment,” he adds.
     

Beyond fundamentals, it’s also a good idea to pay attention to investor sentiment about a particular stock. “Following the herd isn’t a sound investment strategy, but that doesn’t mean you should ignore sentiment entirely,” Steve says. “If investors are starting to sour on a stock, you should question why, since sentiment is often a leading indicator of price decline.”

Bonds

Because bonds are relatively stable, investors are less likely to dump them in a fit of panic selling. On the contrary, bond investors should be wary of panic buying. Consider reevaluating your next bond purchase if:

  • The purchase would upend your target asset mix. Having some exposure to Treasuries makes sense for many investors because bonds are a vital part of a well-balanced portfolio. But think carefully about the appropriate allocation. Don't rush into Treasuries in response to a weakened economy. Remember, time in the market generally beats trying to time the market. During a market downturn, investing heavily in bonds might offer more portfolio stability, but it could throw your long-term financial goals off track. 
  • You’re buying risky bonds in an effort to boost yields. With 10-year US Treasury notes yielding close to 1.6%,1 you may be tempted to explore higher-yielding alternatives. Unfortunately, yields in the riskiest part of the bond market have shrunk, with high-yield bonds offering yields of just 4%—down from more than 6% in the summer of 2020. Letting your desire for higher yields dictate your investment strategy is exactly the type of emotional decision-making you want to avoid. 

    “High-yield bonds have a much higher default risk than their investment-grade counterparts, so if you wouldn’t normally include them in your portfolio, I wouldn’t add them now,” advises Collin Martin, director of fixed income at the Schwab Center for Financial Research.

    That said, if you can tolerate a bit more risk while still adhering to your long-term strategy, investing in high-yield bonds through an exchange-traded fund (ETF) or a mutual fund can help mitigate default risk. “Diversification is paramount when investing in high-yield bonds,” Collin says. “If you’re holding just a handful of individual issues, even one default can have an outsize effect on your overall portfolio.”

So, when should you consider selling a bond? One good reason would be if an issuer’s credit quality has deteriorated to the point where you just aren’t comfortable with the additional risk. Another would be if you simply need the cash. In either case, don’t let a sale throw off your target allocation to bonds—you should still aim to keep your portfolio balanced and in line with your goals.

Funds

It can be tempting to get into or out of ETFs and mutual funds whenever a big market swing occurs. Unless you’re an active trader, however, you should avoid basing your investment decisions on market trends.

Most investors know that trying to time the market is contrary to achieving their long-term goals, but knowing that to be true doesn’t necessarily keep you from making emotional decisions when markets are surging or slumping.

To help keep a level head, predicate your buy and sell decisions on quantifiable factors, such as:

  • Fees. When adding funds to your portfolio, generally favor those with lower operating expense ratiosevery dollar you pay in fees is one you can’t invest for future growth. That’s an easy rule to follow with index funds, whose fees tend to be relatively low, but it’s not so cut-and-dried where actively managed funds are concerned.

    “Paying a higher fee for an actively managed fund could make sense if you believe the fund will deliver superior returns,” says Michael Iachini, managing director and head of manager research at Charles Schwab Investment Advisory. “But don’t base such decisions on past performance, because strong returns could be due to luck and might not persist.”

    The same holds true for those you already own. “If any of your current funds seem overly expensive vis-à-vis comparable alternatives, it might be time to make a switch,” he says.
  • Investment strategy. Whether you’re looking for broad exposure to the market or access to a specific sliver, always confirm that a fund’s investment strategy is in line with your expectations. Two funds that seem similar on the surface could take very different approaches with their investments.

    Likewise, it’s a good idea to check in on your current funds’ strategies periodically—especially your active funds. “Managers may adjust their strategies from time to time in an effort to boost returns or respond to the current environment,” Michael says. “If this happens with any of your holdings, make sure you’re comfortable with the direction in which the fund is heading.”

Cool it

When your emotions are running hot, they can steer you in the wrong direction; slowing down and focusing on the facts can help you make the right decisions at the right time and for the right reasons. That may sound obvious, but it’s harder than you might think—especially in the heat of the moment.

1As of 05/11/2021.

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