Financial Decoder: Season 6 Episode 3
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Transcript of the podcast:
MARK RIEPE: Like many of you, one of my college-aged kids moved back home because of the COVID-19 virus. The good news is that she’s back at school. I miss her, of course, but one consequence of her leaving is that I get to use our home office again.
As I’m recording this, I’m sitting in here, and there are a lot of books. As I look down the hall, into the living room, I see that one of the walls in there is entirely covered in books, and the same goes for many of the rooms in this house.
Believe it or not, there used to be more books in our house, but several years ago we imposed a book cap. We decided that we needed to start pruning, and we started, every so often, to conduct a mini-purge of books.
It went pretty well in the sense that many books found better homes, and we cleared out some space.
Yet, every so often, someone in the family will be looking for a book, and then they’ll stop, look at me, and say, “Oh. I know why I can’t find that book. You made me give it away.”
In my defense, I never made anyone give away a specific book. I merely said they had to cut down, and it was up to them to decide what to prune and what to keep.
Our situation with books is a lot like the situation many people face with their investments. What they have is an unruly collection of individual securities that often needs pruning.
And by “pruning” I mean selling. Because successful investing is about what you buy and when you buy it, but also what you sell and when you sell it.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
We’ve covered some of the cognitive and emotional biases associated with selling way back in Season 1. In fact, I think it was our very first episode.
In that episode we talked about the psychology of the sell decision and how choosing to keep or to sell a stock or other investment can be complicated because of something called the disposition effect.
We also discussed loss aversion. If you’re like most people, a $1,000 loss hurts about twice as much as the positive feeling experienced from a $1,000 gain.
This means you’re reluctant to turn an unrealized loss on a stock investment, also known as a paper loss, into a realized loss by selling it.
Selling magnifies the pain because realizing a loss is tantamount to admitting that you made a mistake.
If the loss is only on paper, you can take comfort from hoping that the stock will bounce back. That hope vanishes once the loss is realized.
The final bias we covered was mental accounting.
It comes into play when, in your mind, you create a separate little account for every position you own.
In effect, you compute the profits and losses on a position-by-position basis and don’t pay attention to the fact that each of these positions is part of a broader portfolio.
That episode was fine, but it was kind of limited. For the most part everything I talked about was from the perspective of someone who owns individual stocks.
On this episode we’ll revisit individual stocks, but in a more detailed manner. We’ll also discuss when to sell an individual bond. And then, Part 2 of this episode will cover when to sell a mutual fund and an exchange-traded fund, or ETF.
Today we’re going to start with Kathy Jones.
Kathy is Schwab’s chief fixed income strategist. Kathy is going to explain when it makes sense to sell a bond.
Next you’ll hear from Steve Greiner. Steve is a senior vice president for Schwab Equity Ratings, and he’lldiscuss what you should consider when selling an individual stock.
But first up is the decision of when should sell an individual bond.
I’m joined now by Kathy Jones. She’s responsible for credit market and interest rate analysis, as well as fixed income education for investors. You can see her on all the major financial networks. She was a guest back on Season 4 when we discussed how to pay yourself in retirement. So, Kathy, thanks for being here today.
KATHY JONES: Well, thanks for having me, Mark.
MARK: Kathy, we’re talking about many different types of securities on this episode, and the question is when does it make sense to sell? Bonds are kind of interesting, in that they’re the one type of security where selling is the exception rather than the rule. By that, I mean most individuals, when they own a bond, they’re probably expecting that they will hold it to a maturity. Has that been your experience? And, if so, why does that make sense?
KATHY: Yes, most investors who buy individual bonds hold them to maturity because they’re really interested in the income stream generated by the interest payments rather than the price appreciation that might occur with the bond. And that’s especially true for investors who structure their portfolios to generate, say, a paycheck in retirement or plan to use the proceeds at a set time in the future. If you sell a bond rather than holding it to maturity, you can really disrupt your financial plan.
MARK: All right. So let’s talk about some situation or events that might disrupt the bond portfolio and see whether those make good reasons to sell. We’re actually recording this in late 2020. There have been bonds whose been … whose credit ratings have been downgraded, lots of them, in fact. So, first of all, what does it mean to be downgraded?
KATHY: A downgrade means that the rating agency, whether it’s Moody’s or Standard & Poor’s, have lowered their valuation of the issuers to pay interest and principal. It doesn’t mean that every bond that’s downgraded will default. It just means that the agency that’s rating them has decided that something has changed that makes the bond riskier.
MARK: So a downgrade means that the odds of the bond not making its interest and principal payments, that’s gone up. Is that, in and of itself, a reason to sell?
KATHY: Not necessarily. It might, but not necessarily. So in some cases, if a bond that was very highly rated is downgraded—so say it starts at triple-A-rated or double-A-rated, and it’s downgraded, say, half a notch—goes from double-A to double-A-minus—it may not change your reason for holding it. There is still a very low risk that there’ll be a default, and it could be that the issuer, whether it’s a municipality or maybe a corporation, has added more debt that put them into a different category of rating. We’ve seen that a fair amount in the investment-grade corporate bond market recently. Companies have taken advantage of very low interest rates to add more debt to their balance sheets. Sometimes they’re just being opportunistic. They’re not actually spending the money. They’re holding onto it for some opportunity down the road because the cost of the money is so cheap. Well, the rating agencies may downgrade them as a result of having more debt, but it doesn’t really change the company’s ability to pay by very much.
MARK: So what about a situation where the downgrade is from an investment-grade rating to below investment-grade? It seems to me that that’s perhaps a more extreme version of a downgrade.
KATHY: Yes. That is a serious downgrade. So in the corporate bond market, when a bond is downgraded from investment-grade to high-yield or junk status, as we call it, it’s called a fallen angel. And the downgrade often results in a pretty hefty price decline because some investors like, say, some mutual funds or institutional investors, aren’t able or willing to hold that bond when it drops below investment-grade, and that’s what leads to the big price decline.
It also means that the risk of default has risen pretty substantially. So if we look at the 15-year average default rate on triple-B-rated bonds—those are bonds at the bottom end of the investment-grade spectrum—it’s about 5.9%. In double-B-rated bonds, which is the top end of the high-yield spectrum, it’s 17.6%. Now that’s a huge difference.
MARK: So that means if you held a bunch of triple-B-rated bonds for about 15 years, on average, about 6% of those bonds would experience a default of some sort. Whereas that double-B-rated bond, you’ve got about three times as much the chance of that bond being defaulted, at least based on historical averages. Is that the way to interpret those numbers?
KATHY: Yeah, it is. It’s just a way to put into numbers how much riskier a high-yield bond would be than an investment-grade bond.
MARK: So let’s talk about defaults then in a little bit more detail. Again, in 2020, there’ve been a lot of defaults. Let’s start by defining, what exactly do we mean by default?
KATHY: Well, a default is a failure by the issuer to pay interest or principal on a timely basis. So that may mean they miss an interest payment or they stop altogether.
MARK: I get a lot of questions from people asking, “Is a default the same thing as a bankruptcy?”
KATHY: No, absolutely not. A bankruptcy is when, say, the issuer enters into a legal arrangement where they may or may not pay all of their debts. A bankruptcy could result in a restructuring of the debt, meaning a bondholder could only get a portion of their investment back or maybe none of their investment back. But in some cases, in bankruptcy, bondholders are protected. It really depends on the situation. It’s a case-by-case basis.
MARK: All right, let’s go back to, then, default. I own a bond. It’s defaulted. Is that a good time to sell?
KATHY: It might be. Again, it depends on what the prospects are for getting paid and what your tolerance is for the risk.
MARK: One of the nice things about online investing is that a lot of websites, for example, Schwab.com, they’ve got great tools that allow you to compare different securities to one another. Let’s imagine I own a bond and I’m looking around on the bond research section of a website, and I see another bond that has a higher yield than the one I already own. Should I sell that bond I own and buy this alternative bond?
KATHY: Not necessarily. In fact, it might be a bad idea. In general, the market is efficient enough that there shouldn’t be a big difference in yields between very similar bonds. If there is, it may be a red flag that there’s something going on that makes that higher-yielding bond riskier. It may not yet be reflected in the bond’s rating, but the market will adjust the price or the yield to reflect that risk. So I would be very wary of just shifting around based on yield alone.
MARK: Another reason I might sell is that, well, you know, I just need the money. Is that a good reason to sell, or is it best to look to sell other parts of your portfolio first before you start looking at individual bonds?
KATHY: Again, it depends. I mean, generally speaking, I would probably look elsewhere first because when you sell a bond, you have to consider if you’re going to be able to replace the income that you’re getting from the bond from another source. And there could be some tax considerations, even if it’s a municipal bond. So, typically, they’re tax exempt, but if you take a gain on it, you may end up paying taxes on that gain. And, also, again, it can throw off a financial plan in a way that another … selling another security may not. So, in general, I would think, you know, it really depends on the circumstances and why you need to sell the bond.
MARK: Kathy, one final question. You give presentations all the time to individual investors. You talk to a lot of people in the financial media. What’s the biggest misconception you come across when it comes to selling bonds?
KATHY: Well, I think the biggest misconception is that bonds are really, really risky because yields are so low. That misconception has led a lot of people to sell out of their bond holdings and sit in cash. But if you hold a highly rated bond to maturity, the risk of losing money is very low. There’s an opportunity cost in holding it if yields move up, and the price will certainly fluctuate, but it’s not going to generate a capital loss unless you sell it. And even if you do sell it, you’re likely to be able to reinvest the proceeds in a higher-yielding bond, which can mitigate some of the costs or the loss by generating more total return over time. You know, really, it’s just important to have a strategy for all types of interest rate environments when you invest in bonds.
MARK: Kathy Jones is Schwab’s chief fixed income Strategist. Kathy, thanks for coming by today.
KATHY: Thanks for having me, Mark.
MARK: I’m joined now by Steven Greiner. Steve is a senior vice president here at Schwab and he’s in charge of our Schwab Equity Ratings department. He also holds a PhD from the University of Rochester and sits on the advisory board of The Journal of Portfolio Management. Steve, thanks for being here today.
STEVEN GREINER: Well, thank you, Mark. I appreciate it. I’m looking forward to it.
MARK: Steve, this episode is about when to sell, and you’re here to talk about when to sell an individual stock that you’re currently owning. What’s interesting to me is that you’re an advocate of thinking about that when-to-sell decision immediately after you’ve decided to buy the stock in the first place. Can you tell me more about that?
STEVE: Sure, Mark. You know, I encourage every investor to keep a journal or a notebook, and after you’ve done research on a stock you’re interested in and you decide to buy it, write down not only the transaction details, but every reason for owning it, how long you plan on keeping it, and when and under what reasons you might sell. It’s a great idea to get started.
MARK: What I like about that suggestion is it’s really a great mechanism for putting in place some discipline. By thinking about that sell decision ahead of time, it seems to me that you’re less likely to fall in love with the stock because you’re explicitly recognizing right away that there will come a time when it’s time to part ways with the company. So let’s get more specific. What are good reasons to sell? What are the conditions that you would be adding to your checklist if you were buying a company?
STEVE: Well, that’s a good question. There’s many reasons to sell a stock, the chief of which, though, is your reasons for buying a stock in the first place are no longer valid. That’s why you should write down your reasons that you need to buy, and look around and remind yourself why you bought it, and check to see if those reasons still ring true from time to time. Six months later, you generally would never, you know, know. Good reasons to sell, one of them would be that, you know, a stock with a P/E of 20 is now 35, for example, or it hit a price or profit target you had set and that you had written down.
MARK: So the idea is that if the … let’s say, the price-earnings ratio, or P/E ratio, if it started at a low level, and now it’s at a much higher level, then that stock might be pretty expensive relative to its underlying earnings power, and it might be time to get out at what, frankly, may be the top. Is that a fair summary?
STEVE: Yes, Mark. I mean, the P/E could rise for two reasons. One, the price has risen dramatically, and now the valuation of the company is much higher relative to its earnings, and that’s called multiple expansion. Secondly, of course, its earnings have fallen dramatically relative to the price, and you have a worrisome condition that the firm is really under some stress. In both cases, the valuation is now too high and it may be a good reason to sell.
MARK: Yeah, in both cases, you’re, in effect, paying a lot, or the stock is trading at a lot relative to its real underlying earnings power, which is really, frankly, what you’re buying it for in the first place. OK, what’s next?
STEVE: It has to take in a lot more debt than it originally had, maybe. Highly indebted companies are generally of lower quality. So you want to look at the debt—what was it when you bought the stock? What is it now? Has it acquired a lot more? And that’s usually a sign of a lower-quality condition.
MARK: What you’re really getting at there is it’s really about risks. The company now has a much bigger debt load that makes it riskier. In some respects, it’s a different company than when you bought it. Is that a fair summation?
STEVE: That’s correct. Both … you know, quality being measured both by valuation and/or by debt levels. Both are really a type of measure of risk.
MARK: So those are two great reasons. What about a third one?
STEVE: Well, the third one is more interesting and easier to see. Let’s say a company just announced that it’s a takeover candidate, and the price rose very close to the acquisition offering. You would sell here because it’s highly unlikely to rise above the deal price. And if the deal falls through, the price will drop. So you might as well take profits. And if the deal does fall through and the price falls, you can always buy it back at this later price if the reasons you bought it still hold after the deal falls through.
MARK: Yeah, probably the only way that that stock is going to go higher is if another bidder comes out of the woodwork and bids an even higher price for the company.
STEVE: Yeah, that could certainly happen, but it’s rare to do so. And it’s extremely hard to predict.
MARK: Steve, we know a lot of clients like to pay attention to dividends, and they’re attracted by a high dividend yield when buying in the first place. Can the dividend yield be used as a selling signal in addition to being a buying signal?
STEVE: Yes, Mark, and it actually certainly should be. If you bought a stock with a nice dividend yield, and by nice, I don’t mean overly large, and suddenly, say, it doubles, you know, in one quarter, that’s usually a sign that the price fell, and you might have noticed that, if not, the yield will tell you. But it also means the company is probably under some duress, and the board just didn’t get a chance to meet yet to cut the dividend to conserve cash. So, generally, you know, high dividend yield rising sharply is a bad sign.
MARK: One thing I’ve heard investors tell me is I’m just waiting for the stock to get back to breakeven, and then I’ll sell. What do you think about that strategy?
STEVE: I don’t like it. You know, never fall in love with a stock. First of all, there’s an opportunity cost with waiting for a stock to rebound. You might have to wait years. Plus, imagine a stock trading at $100 a share, you know, it falls 20% to 80 bucks. It has to rise 25% to get back to $100 a share. If it falls 40%, say, from a $100 to 60, it has to rise 67% to get back to 100. The more the stock falls, the greater regret you’ll have, and the more enticing it is to stay with that stock waiting to break even. But the odds of it rising in a reasonable amount of time to recoup those losses, it’s much lower than you think because it has to increase at a much higher percentage than it fell. Better to accept your losses and move on.
There would only be one reason to keep that stock, and that is if the reason you bought it in the first place, those reasons are still intact.
Additionally, if the stock has fallen a lot, it’s usually for good reason. Stocks don’t fall from 50 bucks to 25 without usually some good reason, which means the company has to, you know, restrategize itself. It’s got to find its footing, redevelop its business plan, maybe replace executives. You know, this kind of strategy rebuild could take years. You know, GE is a prime example. So do you have years to wait? You know, probably not.
MARK: Yeah, just because you bought a stock at 100 and it’s trading at 80, there’s no law of the universe that says it has to go back to 100. I mean, the market literally doesn’t really care what you paid for a company. That’s what it really comes down to, right?
STEVE: Yes, that’s a good way of saying it.
MARK: What are some other popular reasons to sell individual stocks that,they seem to make sense, but don’t work out so well in the real world?
STEVE: Well, selling a stock because the price has fallen, like we’ve just talked about. But it’s tricky. It’s true if you’ve done your homework well, and when the price drops and the fundamentals and reasons you bought it haven’t changed, you know, then don’t sell it, but only if the fundamentals remain strong. Then it could even be a buying opportunity. On the other hand, you know, consider selling it if your original thesis for investing in the company is busted, whether the price drops or not. Which is why you keep a notebook—so that you can go back and remind yourself what your original reasons were for buying it.
MARK: Steve, we’re recording this in 2020. There has been a lot of market turbulence this year. How does that fit into the selling calculus? You know, people see these big movements and volatility, and they say, you know, “I’m just going to sell these names right away.”
STEVE: Yeah, when the market moves big, you know, people feel like they have to take action. They just can’t sit still. So selling because the market is in turmoil is really a bad reason to sell.
Understand that when the market is falling dramatically, the correlation between stocks tightens up. You know, in the trade, they call it going to one. Most stocks fall in a collective sense. But this is the wrong time to sell. When these events happen, these events are usually unrelated to individual company fundamentals. Investors are just selling en masse to get out of the market out of fear. And the underlying companies can be just fine because nothing’s really changed with the business, and, in fact, it may be a good time to buy when all the dust, you know, settles.
MARK: Yeah, what you’re getting at there with the correlation between companies when you say the correlation is going to one, that means all companies are kind of moving in the same direction. And if all companies are falling, that doesn’t make a whole lot of sense because the companies and their prospects are so different, right?
STEVE: That is correct. Examine the companies you own. Look at your notebook. Ask yourself, you know, is the reason you bought them no longer valid at this price? If not, it could signal to buy more. But be cautious and slow to make a decision. Slow your decision-making down during these times. That will certainly help.
MARK: I think that your point there about slowing down a little bit, that’s an interesting one, because it is easier than ever to stay connected to news about the companies you own. You can sign up for alerts about a company, and, you know, every minute something happens, you might be getting an alert. Your phone is chiming, and there’s a piece of news about the company. Let’s say you got a piece of bad news. Is that, by itself, a reason to sell?
STEVE: Not necessarily, Mark. It’s really a knee-jerk and emotional decision to sell because bad news came out. First of all, never sell based on emotions. Also, consider that when you own some securities, you’re sensitivity to the news just goes up. It’s like when you buy a new car, suddenly all the cars you see are your car. Same thing happens with stocks. So you got to be careful that you don’t react emotionally, just because you hear bad news. Instead, revisit why you bought the stock and ask yourself, are those reasons no longer valid? Remember, bad news travels faster than good news, too. So you’re always going to hear about that quickly. But you have to, you know, prevent yourself from knee-jerk reactions and acting emotional.
MARK: Steve, you know this, I know this, picking stocks is hard to do, and it isn’t surprising that reasonable analysts who are very experienced, they can come to different conclusions. How should an investor navigate seeing reports that you should sell a company, other reports saying you should hold onto a company, other reports saying you should buy the company? What do you do with all that information that’s out there?
STEVE: Well, Mark, the first thing I do is I really look at, you know, some of the fundamentals of the company myself before I read any analyst ratings. You want to give yourself some credit that you can understand some simple ratios. If you go to Schwab.com under Stock Research, you can click on Ratios. In just a few minutes, you can pinpoint, you know, the company’s valuations, earnings-per-share growth, sales growth, dividend yield, payout ratio, various different attributes of the company’s financials. And even just knowing the spread between the enterprise value and the market cap gives you a feeling for the size of the debt. Hence, before you read what an analyst thinks, you’ll already have a pretty good measure of where some risks might be in this stock. You can compare, for instance, the P/E to the earnings-per-share growth rate. You would like them to be, you know, roughly equal or so. So you can read about these, get some, you know, opinions yourself. Then you can go and read what analysts think, and you’ll be better armed to deal with that.
Also, you have to be weary of analysts who might weigh the majority of their opinions in a future or forward-earnings forecast. Those are nice to see, but you don’t want to give them too much credit for, you know, the forecast for a firm. Warren Buffett and Ben Graham hardly used any forward estimates in their analysis. It’s like using a forecast to make a forecast.
Also, you know, pay attention if an analyst says to sell. Wall Street analysts are highly asymmetric on their forecasts. The profession makes them more bullish. So the number of buy recommendations usually outweighs the sells by a wide margin. So if they say to sell, it’s an exception to the norm, and you really should pay attention to that.
MARK: Steve, last question, and I’ll let you go. What are some of the reasons people hold a stock when they probably should be selling it?
STEVE: Well, Mark, the two greatest ones involve capital gains and inheriting it. You know, I don’t want to have a capital gain. That’s a chronic reason to not sell. But, you know, again, if you look at that company that you have and you ask, you know, based on what you wrote down when you bought the security, “Does it meet the criteria that I wrote down when I bought it?” If it no longer does, you know, then it’s a time to be selling, and if you hang on to it longer, you could set yourself up for losses. You know, having capital gains is a better problem than having capital losses. So, you know, you should just, you know, take your gains and go.
Second one is you inherited it. You know, people will hold stocks for sentimental reasons, obviously. But you can’t fall in love with stocks. They’re not people. You don’t want to love them. If it’s sentiment you want, you know, sell the stock and go buy some, you know, collectible or an art. You know, you don’t want to hold stocks for emotional reasons. It’s just not an asset, you know, right for that.
MARK: Steve, this has been great. Thanks for stopping by.
STEVE: My pleasure, Mark. Take care.
Deciding what to sell is just as complex as deciding what to buy, but I think it can be boiled down into a single principle.
Consider selling when either you or the security you own has changed in a fundamental way.
By that I mean buying a security is like buying a product at a store. It’s supposed to serve a function for you.
If it isn’t doing the job that you need done, then you should return it to the store, sell it on an auction site, or give it away.
Securities are no different. They have a function to perform. If they aren’t performing that function, then you should replace them.
It’s also the case that sometimes you change, and your goals as an investor change. Many pieces of your portfolio might be perfectly good investments, but they may not make sense for you anymore because of where you are in your life.
It’s like the book purge I talked about at the beginning of this episode. You might have loved a book in high school, but now that you’re older and wiser, you’re not so attached to it anymore and can get rid of it without regrets.
With other books, the decision may be tougher. But if you never refer to or reread a book, and have no sentimental attachment to it, then really, is it worth keeping?
Still, it can be a hard thing to do, just as selling out of your portfolio can be difficult. But hopefully Kathy and Steve gave you a better sense of factors to consider and provided tips around what to think about and what not to think about when selling.
Thanks for listening.
You can learn more about when selling a stock or a bond might make sense for you by visiting the Insights tab on schwab.com.
If you are a Schwab client, you can access a range of tools that will help you evaluate when to sell by clicking on the Research tab after you log in to your account.
You can follow Kathy Jones on Twitter @KathyJones, and you can follow @MarkRiepe.
Finally, this is our 38th episode, and it’s also our two-year anniversary of doing this show. We’re delighted to see the download count accelerating season after season, and we are most appreciative to our listeners for making that happen.
For important disclosures, see the show notes and schwab.com/financialdecoder.
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When Should You Sell? Part 1: Stocks and Bonds
Successful investing is about what you buy and when you buy it, but also what you sell and when you sell it. So how do you decide which stocks and bonds to sell when?
After you listen
- Learn more about stock fundamentals, like P/E ratio, earnings per share, and dividend yield.
- Read Bond Insights to stay aware of trends in the fixed income market.
- And if you’re a Schwab client, you can access a range of tools that will help you evaluate when to sell by clicking on the Research tab after you log in to your account.
The very first episode of Financial Decoder discussed the sell decision—in part because there are so many cognitive and emotional biases that come into play with that decision. Many people are prone to something called the disposition effect, which is the tendency to sell assets that have increased in value but hold on to investments that have dropped in value.
In part one of this special two-part episode, Mark Riepe analyzes the decision of when to sell an individual stock and an individual bond. First, Mark talks with Kathy Jones, Schwab’s chief fixed income strategist. They discuss whether or not you should sell a bond if it’s been downgraded, if you should sell before the bond’s maturity date, and how defaults and bankruptcies might affect your decision, among other topics. Next, Mark speaks with Steven P. Greiner. Steve is a senior vice president and head of Schwab Equity Ratings. Steve and Mark consider whether you should sell a stock based on changes in its fundamentals, such as P/E ratio and dividend yield, as well as how to react to bad news and big swings in the market.
Part two of this episode will examine the decision of when to sell a mutual fund and an exchange traded fund, or ETF.
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Financial Decoder is an original podcast from Charles Schwab.
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