December 16 2012|
Your portfolio is destined to take a hit at some point in your investing life. But what should you do when it happens? Sell? Buy more stock? Do nothing? Beyond whatever emotional response you will experience from the loss, your follow up will largely have to do with your individual financial situation. In this article, we'll give you some pros and cons of each action, as well as some guidelines on how to evaluate your stocks to help you decide how to rebound from a portfolio knockout.
Three Options for Bouncing Back
When deciding whether to increase, decrease or maintain your holdings, there are a few items to consider. Let's take a look at the pros and cons you will face in the financial boxing ring:
Sell
- The Pros:
Throw in the towel. Liquidate your positions, and you won't sustain any other losses. In addition, the current losses can be used to offset other securities investment capital gains and may be used as a carry forward on your tax return (if applicable).
- The Cons:
You don't have the ability to enjoy a comeback when/if your stocks heal and rebound.
Buy More
- The Pros:
Go on the offensive. By averaging down in certain positions, you can reduce your cost basis. Once you do this, you'll have the opportunity to buy shares of a particular company you like at an even cheaper price than your initial buy in.
- The Cons:
If the entire portfolio or some positions continue to take a beating in the market and head toward a total knockout, it could have a marked adverse impact on your future investment returns.
Do Nothing
- The Pros:
You could get lucky and the portfolio could rebound on its own, freeing you from having to rebalance it.
- The Cons:
The punch you received from your portfolio gets to keep knocking you down. Or, if you were too stunned from the first hit to make an advance on the now lower priced value stock, then you lose your opportunity to make money.
Time Out: Assessing the Damage
To get yourself back in the fight, you will need to assess the damage. Start by looking at the overall value of your portfolio to determine what percentage was lost. This should help put things in perspective and let you know how aggressive (or passive) you may have to be to come off the ropes for a second round. Also, you should pay particular attention to what types of investments took the biggest hit. This will give you some ideas about which sectors seem more resilient, and which might fare better going forward.
Here are a few more factors that will help you get your second wind.
Check for Dry Powder
Most infantrymen know the usefulness of keeping some gun powder dry - just in case they might need it. In the same way, investors need to keep a reserve of energy and cash to sustain them when times get tough. Have you kept any cash or money market holdings on the sidelines that you can use to buy more shares (if warranted)? Or are you fully invested and tapped out? This is the time to take stock of what you do have in reserve and see if you can add that to your financial fight. If you don't have anything on the sidelines, this is the time to sit tight and either wait it out or start selling.
Assess Individual Companies and/or Holdings
Look to your corner of the ring. Analyze each holding in your portfolio. Look through the financials and, if necessary, consider calling management to provide an update. Are the fundamentals of a particular holding solid? If so, perhaps it makes sense to take advantage of the recent pullback by buying shares. If the recent decline has adversely impacted a particular company's fundamentals, it may make sense to jettison the holding and purchase another security, or simply place the proceeds/funds in a money market account so that they're ready for another day.
Analyze the Macro Environment
Far too many investors tend to overlook the macroeconomic environment. Check around; who are the fans voting for? If it's not for you and your stock, there could be a good reason. Are you outmatched, outsmarted or outsized? For example, if you don't look at how commodity prices (such as oil, cotton, lumber, etc.) could impact a particular sector or a given company, you could be missing out on how the market will treat your portfolio.
Reassess Risk Tolerance
You should also reassess whether your risk tolerance level has changed in light of recent events. Can you afford to continue taking a beating? Can you afford to lose even more money? Can you afford to go on the offensive, go another round and buy more stock? All of these questions should be pondered before getting back in the ring.
Consider Investment Horizon
Is this your last fight, or are you just starting your career? When will the money in your portfolio be needed? Has that changed in light of recent events or could it change if your portfolio were to take a hit of 20, 30 or 40%? The answer to this investing horizon question will help determine whether you should be buying or selling.
Getting Your Balance Back
If your portfolio were to take a substantial hit, then you would need to consider rebalancing your portfolio to ensure that you are not overly exposed to any one company or sector and/or haven't deviated from your initial investment objectives or allocation.
For example, consider the following investment profile:
15% invested in entertainment
15% invested in technology
15% invested in retail
15% invested in commodity related stocks - oil, gas, gold, etc.
15% invested in pharmaceuticals
15% invested in financials
10% held in cash/money market
Now, if the portfolio were to take a significant hit, the allocation might look something like this:
12% entertainment
11% technology
9% retail
6% commodities
14% pharmaceuticals
15% financials
33% cash/money market
To keep up with your current allocation, you will have to increase certain holdings (such as commodities for example) and decrease other holdings (such as cash).
The Bottom Line
Investing isn't easy, and taking a big hit to your portfolio certainly isn't easy to handle either.
However, investors should be prepared to defend themselves and give themselves time to recover when bad times hit. So stay on your toes, be prepared and don't let your portfolio go down without a fight.
source - http://www.investopedia.com/articles/stocks/08/knockout.asp#ixzz2FEIeWLQu
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