Realizing profits on overvalued stocks may be a prudent strategy
Timing the market is an impossible task. No investor can predict how the stock market will perform in future due to the wide variety of political, economic and other factors that can influence its price level.
As such, seeking to sell stocks en masse in the current bull market in the hope of avoiding the next bear market may not be a prudent move. Other assets such as cash and bonds also offer extremely low returns at the present time because of low interest rates. This could mean that investors who sell all their stocks experience a significant opportunity cost if the stock market’s recent rise continues in future.
The market cycle
However, the current bull market will ultimately come to an end. No previous stock market rise has ever continued without being followed by a bear market. This point was neatly summarized many years ago by value investor Sir John Templeton. He established a fund management company in 1954 and delivered a 15% annualized total return over a 38-year period in the second half of the 20th century.
As he once said, “The investor who says, this time is different, when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.”
A case-by-case basis
In my view, a strategy of assessing the valuations of existing holdings and selling those stocks that appear to lack a margin of safety could lead to an efficient allocation of capital. Holding cash in their place could be a suitable strategy if there are no obvious alternatives among equities that can offer a wide margin of safety.
This plan could provide an opportunity to benefit from a further rise in the stock market. It may also reduce an investor’s exposure to overvalued stocks that could be hit hardest in a bear market. Moreover, holding a proportion of a portfolio as cash may be prudent in any bull market because better buying opportunities could appear in future.
Selling in a bull market
Of course, selling any stock in a bull market requires a large amount of discipline. Investors may naturally view recent upward trends and extrapolate them into the future. Their profits may also make them less aware of risks and more concerned about the prospect of making further returns in future. This may be particularly evident in today’s bull market, where the Federal Reserve’s commitment to a loose monetary policy could tempt investors to remain fully invested.
However, Templeton’s comments on selling in a bull market may prove particularly apt at the present time. As he once said, “The time to sell is before the crash, not after.”
Failing to sell overvalued stocks could lead to severe losses in the next bear market. In my view, realizing profits and either moving into cheaper stocks or holding cash may be an appropriate strategy given the stock market’s high valuations and the risks facing the economy at the present time.
Source : Robert Stephens, CFA