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March 25, 2009

Should I wait until the market comes back?

The question I am asked most frequently these days is, "Should I wait for the market to go back up before I sell the investment I am in and move it into something more appropriate?" As you can imagine, this question generally revolves around selling out of a traditional portfolio to move it into a Snider Method portfolio -- but the answer holds true regardless of the investment.

There is absolutely no reason to wait until the market goes back up to exchange one asset you are holding, in hopes of capital appreciation, for another similar asset. Let me give you an example to illustrate this point:

Suppose you started out with an investment in a diversified portfolio of mutual funds that have a cost basis of $200,000. The market has dropped 50% and your mutual funds have likewise dropped in value. So today, they are worth $100,000. If the market goes up 10% from here, you'll earn 10% of $100,000, or $10,000. At this point, the $200,000 you paid for the mutual funds is irrelevant. The market doesn't know how much you paid for those funds and it doesn't care.

Now imagine you sold those mutual funds for $100,000 in cash. You use that $100,000 to purchase $100,000 worth of a different investment. If the new investment goes up 10%, you will earn 10% of $100,000, or the same $10,000 you would have earned in the previous investment. So long as you are switching to an investment which has a similar potential for gains, nothing is lost by switching. You earn the exact same dollars, given the same returns, as you would have in the original investment.

Let me repeat that -- you are not locking in losses so long as you are exchanging one capital appreciation asset for another that has a similar opportunity for profit.

This is not the case with cash flow investments. The key characteristics of cash flow investments are: 1) Cash flow is money that comes to you while you own an asset; and 2) The cash flow is generally (though not always) tied to the face value of the assets or the amount invested, not the market value.

Suppose you have bought $200,000 worth of actual bonds paying 5%, a cash flow investment. The cash flow from these bonds is $10,000 a year, which is why you bought them. Imagine the value of the bonds fell by 50% and are now worth $100,000. If you sell the bonds for $100,000 and use the $100,000 to buy a different cash flow asset, paying the same 5%, the maximum cash flow from that investment is now $5000. You have just permanently reduced the income potential of the portfolio by half, unless you can find an investment with a yield high enough to make up for the loss of principal.

If you are like many of the people I speak with, you may have this concept of exchange confused with the advice that says never sell when the market is down. Sell is different than exchange. Sell means selling out of the assets to move into something which is much more conservative and has less potential for gain -- like cash -- in which case, you definitely are locking in losses.

So, to make it easy, the rules are:

1. If you are exchanging a capital appreciation asset, for another capital appreciation asset with similar potential for gains, nothing is lost.

2. If you are exchanging a capital appreciation asset for a cash flow asset with yield potential similar to the capital appreciation potential, nothing is lost by switching.

3. If you sell a capital appreciation investment to move it to something with a much lower potential for gain - like cash equivalents or U.S. Treasuries - you are locking in losses and crippling your portfolio.

4. If you sell a cash flow investment  - like a bond or a Snider Method position - for less than it's cost basis, you are permanently reducing the income potential of the portfolio.

My final caution is to be clear about why you are selling an investment. All investments, by definition, are cyclical. Selling because an investment is currently underperforming its long-term average is never a good decision. No investment can be above average all the time. Again, by definition, average means that sometimes it is below and sometimes above. This is not Lake Wobegon where all the children are above average.

Remember that investing is a probability game. The key to successful investing is to select investments, which given their probabilities and characteristics, are the closest match for your investment objective, time horizon and risk tolerance. Then sit back and be patient.

On the other hand, what many of you are realizing, is that you are not in investments properly matched to your investment objective or your time horizon. Your objective is retirement income and you're investing in capital appreciation investments. When that is the case, the time to switch is the moment you realize you are in the wrong investment.

If you would like to learn more about how cash flow investing might be able to help you meet your objectives, I would invite you to attend one of our free, online Investor Briefings. You can find the details on our corporate website at snideradvisors.com.

The opinions expressed should not be construed as financial, legal, tax or other advice and are provided for informational purposes only. All investments involve risk including possible loss of principal. Investment objectives, risks and other information are contained in the Snider Investment Method Owner's Manual; read and consider them carefully before investing. More information can be found on our website or by calling 1-888-6SNIDER. Past performance is not indicative of future results.

Posted by Kim Snider on March 25, 2009 | Permalink