When to Pull Out of the Market

You may have heard that the Dow, an old and reliable measure of stock market performance, recently surpassed 15,000 for the first time in history. The media is making a big deal each time we hit one of these milestones, and it’s generating a lot of water cooler talk and frenzy among the most novice of investors.

As a result, I decided it was prime time for a frank discussion about getting out of the market.

There are a few “truths” about the stock market, or so we’re lead to believe.

Truth #1 is that the majority of people (a.k.a. “the herd”) buy stocks when the market is hot, and sell off when the market tanks.

Truth #2 is that the “smart” people sell when the market is in a frenzy and buy when everyone is panicking.

Reality is probably somewhere in between. Truth #1 is based on human emotion (fear & greed), habits, low-information investors, etc. Truth #2 assumes that reason can trump emotion and that somehow the “smart” people can keep their strategy a secret from the herd (otherwise, it would obviously fall flat).

And so if you consider yourself a smart investor (doesn’t everyone?), the problem becomes discerning whether we’re making smart choices, or if we’ve somehow become part of the herd. These days (early 2013), since the market has been bullish for quite a few years, most of us are facing the same decision: is it time to pull out?

When to Pull Out

Timing a sell is more of an art than a science. However, I tend to live by some simple rules when selling:

• If I’m selling in a panic, it’s already too late. Selling at the top will feel uncomfortable and like I’m missing out, because I don’t have the benefit of hindsight. It’s true, we can miss “the top” of the market, but I also invest with broad trends and not specific timing.
• Investing with a broad mindset means looking at bigger timeframes. Instead of “today, we pull out,”  I say “this year, we pull out” and plan accordingly.
• I look at macro and micro trends before deciding to sell. In other words, how is the broad market doing (Dow Jones and other indicators), and more specifically how is the sector or company that my fund or stock invests in performing? I’m quite likely to own poor performers in an awesome market and vice versa.
• I study popular long-term investors and model my decision-making on the choices they would likely make in the same situation. The Warren Buffet Way is one possible book to start with.

How to Pull Out

You may be familiar with a term called dollar-cost averaging. In simple terms, you buy a set amount of stock (say, $100) every set period (say, 1 month) from your broker. When the stock or fund is priced low, you’ll get more shares, and when the price goes up, you’ll get less shares (same $100 every time, remember?). The idea is that your purchase price averages out over time, avoiding high and low price spikes.

I practice something similar on the back end of investments, pulling out over time rather than all at once. If you have an account where you have to report sales to the IRS at the end of the year, this could be an bookkeeping nightmare, but for the purposes of accounts like IRAs, it seems to work fine, as long as you keep in mind any penalties that might apply to your particular fund or any required balance minimums.

Dollar-cost averaging, on the buy or sell side, allows you to ease your way in and out of markets based on how strongly you feel about buying or selling at the moment.

Another strategy is what I call the “gambling” method because I’ve heard of many gamblers practicing something similar. Suppose I’m unsure about the future of an investment, and my initial $10,000 capital has grown to $16,000 in a few years. I can sell off exactly $10,000 of my position, recouping my initial capital and leaving only pure profit exposed to market forces.

Be Proactive

However and whenever you decide to get out of the market, don’t put off planning until the bottom falls out of your investments and panic selling ensues. Have a strategy in mind and execute accordingly!

This post is not intended as investment advice and is for informational purposes only. Consult with your financial advisor before making any decisions about your investments.