Making Buy, Sell, and Hold Decisions During Times Like These: A New Approach

How confident can you be of making the right decision when opting to BUY, SELL, or HOLD a mutual fund? Obviously, when making such decisions we hope that they will turn out correctly. But usually only after looking back one or more years at important portfolio actions can we see that we were indeed smart, for example, in buying an international stock fund, or in selling some of our small cap holdings. Of course, just the opposite can happen: an investor can look back and perhaps recognize some not so successful decisions, as when he/she bought funds loaded with tech stocks in the late 1990's or in 2000, only to have things turn out badly.

It would seem impossible to be able to make a good estimate in advance of what your chances of being right were. After all, no one can ever claim that they are certain that buying or selling an investment will lead to a good outcome. Investing always involves taking risks; therefore, the true odds of success are always unknown in advance. But are they merely 50/50, 60/40, or improbably, closer to 9 out of 10?

If we could be assured that there was a significant chance of success, we might be much more comfortable in making the difficult decisions that as investors we are required to make, even when those decisions involve merely just continuing to HOLD an investment we previously have purchased. Trying to maximize one's odds for success is related to why, for example, people show more confidence in a fund manager who has a good, long-term track record: We assume that there is a better chance for success with this manager than investing with a fund manager who has shown lackluster results. Among other factors, the successful manager seems to have made better forward-looking decisions about investments than the less successful one.

So, in order to get a better idea of probability of success, it is useful to examine data on how successful such decisions, made under similar circumstances, have been in the past. One might use such data to not only help make future decisions based on probability of success, but ultimately to improve one's results by actually profiting from making more successful decisions.

Given sliding stock prices recently, let's first examine how confident you might be in deciding now whether or not to SELL one or more of your funds. Without any particular framework to help you decide, one might merely think that there is a 50/50 chance that stocks will fall further vs. recover in the not too distant future. In fact, since stocks when considered over the long term rise considerably more often than they fall, one might even assume there is a greater than 50% chance that they will start rising fairly soon.

But how soon is "fairly soon"? If you are willing to HOLD your funds for at least 5 years, then it may not be worth selling any fund since if you merely HOLD, you may be able to do just as well or better than someone who SELLS now and then either never BUYS back or tries to BUY back somewhere down the road. This is the strategy of the "buy and hold" investor and it can make sense as opposed to trying to subjectively figure out when to BUY and SELL, which is akin to trying to "time the market".

But, if you believe as I do, that certain kinds of stock funds can do considerably more poorly than others for periods of as long as 5 years, then you may agree that it makes sense, on occasion, to SELL these funds (some portion or all); you then put the resulting sum in either cash or BUY another type of stock (or bond) fund that seems to have a greater chance of doing better over the next few years than the fund you sold. This can be a particularly effective strategy for people who periodically rebalance their portfolios.

I have done considerable research on just such decisions and will now present what turn out to be reassuring findings.

Looking at the period between Jan. 2000 and July 2005, one might have had a success rate of between 61 and 69% in making either BUY or HOLD decisions by following some pretty simple fund rating guidelines. (These guidelines will be explained shortly). But even more compelling given the current troubling market environment, my research suggests you could have had perhaps an 88-89% success rate by SELLING those investments identified by the same guidelines and putting your money elsewhere for a few years!

How might one define what is a relatively "successful" decision to BUY, SELL and HOLD? We adopted conservative criteria as follows:

BUY: Achieve at least a 10% annualized return.

HOLD: Realize at least an 8% annualized return.

SELL: Show a sub-par annualized return of less than 8%.

We rated the 9 most familiar domestic fund categories and the International category as defined by the Wall Street Journal or Morningstar as either BUY, SELL, or HOLD at the end of each calendar quarter based on a rating system as defined below. We then examined subsequent 1 and 3 year performance for the fund category as given in the Wall Street Journal and the morningstar.com site.

Here are the results. The percentages shown are how often subsequent annualized performance for BUYS, SELLS, or HOLDS over all categories met the criteria as "successful" outcomes shown above):

What these results suggest is that by adopting the guidelines we devised to make these 3 most important decisions when managing your portfolio, you have a pretty good chance of either making a good return (BUYS/HOLDS), or or avoiding a sub-par one (SELLS).

The outstanding success shown in deciding when to SELL a fund belonging to a major fund category, such as Large Value or an International fund, is particularly noteworthy. In fact, most of the fund categories that our ratings would have recommended as SELLs subsequently did far more poorly than the "less than" 8% annual criterion would suggest. Most performed negatively or in low single digits.

Obviously, there are many reasons why you might decide to SELL off one of your funds, such as underperformance compared to similar funds, economic data showing that most stocks are doing poorly and possibly entering into a bear market, etc.

But quite apart from these factors, we used only simple, easily obtained performance data to suggest that certain categories of funds should be sold. While past performance can never be guaranteed to be indicative of future results, it is one of the best and only indicators we have readily available.

As the experts will tell you, good past performance does NOT necessarily indicate good future returns. In fact, "too good" past performance, when sustained over years and years, is often a sign that trouble may lie ahead. That is why we often do not use past performance, as many others do, as a positive sign, but rather as a strong SELL warning. (More information on this below.)

The data we have researched thus far covered hypothetical decisions made over a 5 year period, followed by the ensuing performance over the ensuing 3 years, including right up to the end of June 2008. This period included both the onsets of a bear market and a bull market, appropriate times in which to test our assumptions.

We recognize that our objective decision-making model was constructed "after the fact" and therefore may not perform as well when applied to decisions made in the future. Although the model is quite formulatic in arriving at its conclusions, it is actually very similiar to the approach we have been using since 2000 to outperform the S&P 500 which did not attempt to use such strict criteria to conclude which fund categories should be bought, sold, or held.

We intend to continue testing how decisions made after July 2005, the above data cut-off point, would have fared using our model. For example, here is a small sample of what our decision-making tool would have suggested recently:

Last Oct (2007), our new approach would have identified all the major categories as SELLs, except Large Growth and Large Core which would have be classified as HOLDs. No categories would have been recommended as BUYs. Although it will take another 3 mos. time to check the 1 year return and much more time for the 3 year return, so far, all of these categories are showing sub-par returns.

The last time during the 2000-2005 period that so many categories were SELLs at the start of a quarter and none were BUYS were in Jan. and April 2000 when 9 of 10 categories were SELLs. Over the next 1 and 3 year periods, subsequent returns for each of these SELL categories were below the 8% criterion more than 94% of the time, and mostly negative! The single remaining category, Small Value, which rated as HOLD, subsequently showed double digit positive returns in the year subsequent to the ratings, although dropped to only single digit positive returns after 3 years.

Implications for Buy, Sell, and Hold Decisions

-First, SELL funds in categories that are "overvalued" (defined shortly).

-Second, BUY funds in categories that are "undervalued". But, this 2nd principle only applies if there is also significant positive performance improvement during the last year or so; this is sometimes referred to as "momentum", also defined shortly.

But how can one easily recognize over- and under-valuation? Because stocks as a whole, long term, average about a 10% annualized return, whenever the universe of large numbers of stocks exceed average returns of 15% per year over periods of 5 or more years, they are very likely overvalued. Likewise, whenever a grouping of stocks average annual returns that are significantly less than 10%, or most drastic of all, negative, over 5 or more years, they are likely undervalued.

We assume the widely accepted notion that, as a whole, stocks that have outperformed their long-term averages will eventually underperform so that their results will return to their former averages. This is known technically as "regression to the mean". The idea is that a group of stocks cannot keep outperforming forever. Aside from a mere mathematic explanation, we know that the economy tends to run in up and down cycles. And when investors profits are strong over a number of years, if they begin to see major signs of trouble that could likely impact all stock funds (as appears to be the situation now), they will be strongly inclined to take their profits from that overvalued fund and find a "safer", less overvalued investment instead.

While momentum suggests an outperforming category of investments will continue to perform well for quite a while, overvaluation likely will set a limit. Therefore, positive momentum should be used to help make BUY decisions only if the investment is also undervalued (the 2nd principle above).

Third Quarter 2008 Model Portfolios

I could devote a whole Newsletter to discussing our current allocations vis a vis the current economic downturn. However, I think most of the discussion that I have already published beginning with the Jan. '08 Newsletter is still valid. (Be sure to look over our June '08 letter if you havent already. In it, we made the case that stocks were in a bear market rally; since I wrote that article, the S&P 500 has gone down rapidly and is again touching bear market territory.

Current Allocations

For Moderate Risk Investors

For Aggressive Risk Investors

For Conservative Risk Investors

Stock Portfolio

Bond Portfolio