Maybe You Should Sell Some Stocks

Not everyone should sit still despite the market's turbulence.

When stocks were having an especially rough go of it in early January, one of my friends asked, "Should I make any changes to my investments in this crazy market?" Before I could answer, she corrected herself. "I know, I know. You're going to tell me not to sell. Everyone says not to sell."

There's a laundry list of good reasons why not selling stocks in periods of market stress has become conventional wisdom. Emotion--specifically, fear--could be clouding your judgment. And if you have a long time horizon, you should be a buyer of stocks when they're down, not a seller. Far too many investors have exhibited a tendency to reduce their equity exposure at the tail end of a bear market; when stocks rebound, they're on the outside looking in. And all-or-nothing market shifts--you're all-in on stocks one day, all-out the next--are conducive to poor investment results.

But one-size-fits-all asset-allocation recommendations--including the admonition not to sell anything in down markets--invariably don't fit some. In particular, investors who are getting close to retirement and have been taking a "let the good times roll" approach to their portfolios may want to use the recent market sell-off as a wake-up call to take some risk out of their portfolios. For them, selling stocks may not just be psychologically beneficial; it may be entirely warranted from an investment standpoint, too.

Hands-Off Investors More Equity Heavy Now 

One unifying theme among most (but not all) strategic asset-allocation plans is that the equity piece of the portfolio declines as the investor gets closer to needing his or her money. The rationale is straightforward: For near-term expenses, it's safer to have the money parked in assets where there's a low probability of having a loss over that short time horizon. That argues for holding cash and bonds for the portions of the portfolio that will supply spending needs for the first part of retirement (or fund almost any goal you hope to achieve within the next 10 years, whether amassing a home down payment or paying tuition). Meanwhile, stocks are much less reliable for short-term cash flow needs; they have greater long-term potential but a higher potential for short-run losses.

But investors who have been employing a laissez les bons temps rouler approach have seen the high-risk portion of their portfolios increase in the past seven years, while the lower-risk piece (to the extent they ever had it) has declined in importance. Even factoring in the recent sell-off, stocks have roughly tripled since scraping their lows in March 2009. Bonds haven't been terrible, but they certainly haven't kept up. 

Thus, a portfolio that consisted of 50% stocks and 50% bonds seven years ago would be roughly 70% equity/30% bond today, assuming the investor had not added to stocks but was reinvesting her dividends. The investor who came into the rally with more than half of her portfolio in stocks, or used stock market strength as an impetus to add to her stock holdings, would have an even higher equity weighting.

Risk Capacity Trumps Risk Tolerance 

Some investors hurtling toward retirement might argue that they have a high pain threshold. They've been stress-tested and they know they can handle the volatility that can accompany a high equity weighting. They didn't freak out in 2008, and they may have even added to their stock holdings on weakness.
But there's a difference between risk tolerance and risk capacity. Risk tolerance is how much you can lose without feeling psychic discomfort. Risk capacity, by contrast, is how much you can lose without changing your plans. As you get closer to retirement, your risk capacity declines, even though your risk tolerance may still be that of a 30-something.

If you haven't built up enough short-term reserves because you've been focusing on your risk tolerance instead of your risk capacity, your retirement plan is that much more vulnerable to sequence-of-return risk. That means that if you encounter a lousy equity market early on in retirement and need to spend from the declining equity portfolio, that much less of your investments will be left to recover when stocks finally do. Your only choice to mitigate sequence-of-return risk--assuming your stock portfolio is in the dumps and you don't have enough safe investments to spend from--will be to dramatically ratchet down your spending. Needless to say, that's not something most young retirees are in the mood to do.

Further compounding the case for derisking a portion of your portfolio if you expect to retire within the next 10 years is that valuations, while not exceedingly expensive currently, aren't especially cheap, either. That means that investors selling today aren't selling themselves out at distressed levels, even though the market has stumbled a bit recently. The typical stock in Morningstar's coverage universe was trading at a roughly 11% discount to fair value as of Feb. 3, 2016. That's not too discouraging, but many of the bargains are clustered in cyclical segments of the market like basic materials and energy. Due to global economic malaise, they could stay down for a while. The so-called Shiller P/E ratio tells an even more glum tale.

How Much Safety Is Enough?

That's not to suggest that everyone should be a seller in the current market environment. Younger investors with very long time horizons should heed market experts' admonitions to not sell anything. And people nearing or in retirement should be sure to hang on to some stocks, too. After all, returns from cash and bonds are unlikely to keep up with inflation over time. To help preserve a portfolio's purchasing power, even older retirees need the growth potential that can accompany stocks. - morningstar