How To Know When To Take Profits? A Discussion Of Fear And Greed In Stock Market Investing

San Francisco Sunset TransAmerica BuildingThere are two things investors need to battle on a constant basis. The first thing is fear. We must eradicate fear when markets are collapsing because we know great fear is when fortunes are made. I distinctly remember when the S&P 500 closed at its low of 666 on March 6, 2009. The mark of the devil was such an insult to injury on Wall Street that hardly anybody decided to buy that day.

Fear can be overcome through experience as we’ve seen a rebound in plenty of asset classes time and time again. We’re seeing a tremendous recovery in housing right now for example. Having a cash hoard so great that you can withstand any amount of body blows is also a key element of combating fear. But feeling secure is not the way to make money. You’ve got to actually get over your fear of losing your security by deploying funds that will initially lose money since nobody can time the bottom.

Greed is the other element an investor must overcome. The desire to make an ever increasing amount of money has ruined people’s lives. Back in the dotcom bubble of 1999-2000, I had several friends who were paper millionaires and unwilling to sell their dotcom company shares out of belief prices would only go higher. Not only did their company shares tank, they ended up owing taxes on the value when their options were exercised. Let’s say you exercise $1 million worth of options at $100 a share. You decide not to sell and the stock detonates to $10 a share. You still owe about $500,000 in taxes on the $1 million even though your shares are only worth $100,000! Another win for government.

Let me tell you another story about greed. The owner of a deli I went to for 11 years in downtown San Francisco was a jovial fella who used to make the best banana nut muffins. He margined up his $50,000 in capital to $200,000 online. One morning after the collapse he revealed to me over coffee that his portfolio was valued at $800,000 at the peak. $800,000 was enough to move back to his home country of Iran and live like a Shah for the rest of his life. Instead of selling everything to fulfill his dreams at the age of 32, he hung on and lost over $150,000 from his initial $50,000 investment due to margin. That’s a $950,000 swing. I stopped in last month to pay a visit. 13 years after the dotcom collapse he’s still making breakfast burritos and banana nut muffins for whiny customers at the age of 45.

TWO SIDES TO EVERY ACTION

As an economics major in undergrad with a focus on finance during business school, I’ve been trained to think in Yin Yang terms. When the economy is improving the stock markets tend to follow suite due to an increase in corporate profits. More people find jobs and the world is a better place again. When I’m sitting in mega traffic thinking of bashing the Mercedes in front of me, to calm my nerves I think how wonderful it is everybody is working again so that my investments go higher.

What people forget during good times is that when there is a tighter labor supply prices go up for everything including rent, gas, food, and interest rates. Prices go from P1 to P2 and suddenly it becomes a little too painful at the pump to commute to work 40 miles a day. Interest rates inch up making your wasteful car payments no longer affordable. If salaries get too high companies begin to slow down hiring or even fire the now overpaid elder staff. You might even see a demand curve shift to the right due to expectation changes in incomes. The list goes on and on.

The rich are getting really rich in a bull market, while those who rent and diligently save but do not invest get poorer by the day. If you do not own real assets, you can kiss your happiness goodbye as things become unaffordable. As the middle class slows down consumption, so begins the decline in corporate profits. Thankfully the trend is up and to the right. But let’s not kid ourselves about the cycles in between.

supply-and-demand

RECONCILING PREDICTIONS

My 2013 predictions state that the S&P 500 will climb 8.8% to 1,551. The post goes into detail how I came up with a 1,550 target price. At the close of March 8, the S&P 500 ended at 1,551.18 and it’s now looking like my call is a little too conservative. I had to make a decision Friday morning whether to let my investments ride or take profits. Things are obviously recovering quite handsomely and the sequester fear mongering did nothing but provide happiness to the rest of us given the government finally has to eat their own poop.

During my decision making process, I thought back to the 1997 Asian financial crisis, the 2000 dotcom meltdown, SARS/bird flu scare in 2003, and the Armageddon of 2008-2010 to remind myself of financial pain. I looked at the composition of my net worth on Personal Capital to see a full 73% of my wealth leveraged into the stock market and real estate market. Things felt good, but feeling good is almost always temporary.

Most of my equity exposure is in investments that cannot readily be sold (structured notes with 2-5 year time horizons, deferred compensation in the form of company stock, private equity etc). I like to feel in control of my finances, even though I may only be experiencing the illusion of control. Selling real estate is an entirely different ordeal that doesn’t make sense now given we’re in a multi-year upcycle and transaction costs are prohibitively expensive. The only thing I can easily adjust is my 401k.

I came to the conclusion that it’s time to be disciplined and sell equities. My 401k is now 80% in stable value (50%) and fixed income funds (30%), and only 20% equities. The stable value funds should return at least 1.7% risk free for the remainder of the year. Meanwhile, I see value in 10-year treasuries above 2% over the short-term, but not over the long term. I believe the S&P 500 is fully valued at ~16X-17X earnings. Rising interest rates and $4+/gallon gas will slow down the pace of consumption. Meanwhile, the sequester effect will start to be felt over the next six months.

BE HAPPY WITH WHAT YOU WANT

If I’m wrong, then great. A rising stock market really helps those in the top 20% who own over 90% of stock market wealth. A rising stock market also helps everybody thanks to an improving labor market. Just like how nobody can pick the bottom, nobody can pick the top either. The momentum is there and we may very well keep charging to 1,600 on the S&P 500.

With my 401k rebalance, I’ve now freed up time to focus my efforts on making money elsewhere. There are so many rental properties to see and so many online projects to execute. Perhaps the markets will rocket much higher, making a 8.8% prediction look completely silly. But at 1,551, I’m happy to wait. I’ve survived another year of not losing money and I hope the same goes for all of you.

To Recap: Deciding On When To Take Profits

* Review your predictions for the year and see what has gone right and what has gone wrong.

* Think about the various positive and negative catalysts in the economy that may improve or derail your arguments over the next six months.

* Reassess your financial situation. Do you have stable cash flow? Do you have passive income? Are there changes on the horizon such as an upcoming expense or an impending retirement?

* Evaluate current valuations and expected earnings 12 months out. Are they reasonable?

* Look for new opportunities and laggard stocks and sectors. Everything is relative in investing.

* Remind yourself that you can never lose if you lock in a gain.

* Repeat the cycle once you’ve mustered up the courage to invest again.

Recommendation: The best way to growth your wealth is to stay on top of their finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where to optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going. Their 401K Fee Analyzer tool is saving me over $1,000 a year in fees I had no idea I was paying. There is no better free platform out there that is helping me manage my money. The entire sign-up process takes less than a minute and is free.

Photo: San Francisco Sunset, TransAmerica Building, 2013, SD.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Pauline says

    it is hard not to regret an exit that was too quick. generally put a stop loss instead of cashing out, but since it is always a pivot level the price tends to come back to my stop loss before reaching higher. If it shoots straight up, I move the stop loss gradually.

  2. JC @ Passive-Income-Pursuit says

    This is something I struggle with because I have a few big winners that should at least have their positions trimmed if not closed out and then get back in when the prices are better. It’s the normal investing quandary where the price always shoots up after you sell. But as the saying goes bulls make money, bears make money, pigs get slaughtered.

  3. My Financial Independence Journey says

    I prefer to establish a priori guidelines for buying and selling that fit in with my overall investment strategy. Because dividend growth investing is a buy and hold game, my rules are based on fundamental changes to the company or the dividend stream rather than short term changes to the stock price. My portfolio value may go up and down like a roller coaster, but so long as my holdings continue to make money and distribute that money to me, I’m fine with being patient.

  4. krantcents says

    I think this is a good reminder even if you choose to ignore the advice! Everyone is different and invests for different reasons. I invest for growth and picked segments as well as diversified indices to take out some of the volatility. I try to focus very long (30-35 years) term. I may feel different in retirement, but I am not dependent on my portfolio to support me in retirement.

    • Financial Samurai says

      They are ones that don’t lose value given the composition of various cash funds and low risk bond funds.

      Fidelity MIP III Fund is one such example and a Fixed Interest Fund by Mass mutual is another. Think of it like a money market plus fund.

  5. roger says

    Personally, I use Shiller’s PE10 to modify my asset allocation percentages when the market is high/low. I think the market is a little high right now based on PE10 but I won’t even guess when there will be a decline.

    • Financial Samurai says

      Good question. I’ll have to revisit my risk exposure again as I’m doing now. If we get to 1,600 this year, I may even be tempted to go back to work as the economy will be rocking and pay in the finance industry will also follow suit.

      Given my real estate holdings, this is the asset class where the real juice happens due to leverage. Stocks are very low octane in a bull market compared to real estate.

  6. JayCeezy says

    I come for the photos, but stay for the wisdom. Very sensible and clear post, once again FS.

    This is the part where I offer my words, but at this point with my track record, all I know is my next words are going to be “famous last word”:-)

  7. Jeremy Johnson says

    My stock portfolio is up over 8% so far since investing in late December last year. My strategy is to get passive income with dividends, but at 8% in just over two moths, it is very tempting to just sell all and take the gain and wait for another dip. I’m still going to hold though as I will have short term capital gains to deal with if I sell now. If the stocks go up another 8 to 10% though…

  8. Spencer says

    I like how in depth you’re thinking about this. However, I think you’re trying to outsmart the market here. Why not just buy and hold for the long term rather then thinking about your returns year to year?

    I can understand if your risk ratio is out of balance, i.e., your equities comprise 70% of your portfolio when your diversification profile says you should only be 60% into stocks. Then I would understand selling shares to purchase more fixed income products (bonds, Lending Club, etc.).

    But I don’t really see you making that argument in your post. I see a lot of emotion and fear that the market is overpriced and will decline, so you want to get out while the gettings good. Again, I think that’s an emotional response and not approaching the issue logically.

    I don’t know where the market is going to go this year. Or next year. Or any year. I don’t really care. I know that a buy and hold strategy, while rebalancing maybe once a year to fit a risk profile (75% stocks, 25% fixed income for example), historically has returned 6-7% after inflation for the last 140 years. Do I think the next 140 years are going to be crazier than the last 140 years, with all the depressions, recessions, wars, booms, busts, and technological progress? Maybe, maybe not. I’m confident we’ll get through it just like our fathers, grandfathers, and great-grandfathers did.

    What I do know is that actively trading and trying to time the market is a great way to put money into the stockbroker’s pocket and to miss out on excellent opportunities for wealth creation.

    A long response, but I know that for myself, I’m not cashing out. Good luck to you whatever decision you make!

    • Financial Samurai says

      You’re probably right, which is why you’ve built up a solid net worth of $10,000 with a plan to triple it by year’s end vs me just struggling to grow my net worth by 10% a year or so. You’ve got the cash flow to withstand the hits. I just want to have enough to pay the bills hence the fear.

  9. Rich In The Heart says

    I just recently used a trailing stop order for the first time in one of my portfolios. it was somewhat interesting to see it play out. Originally had it selling all the shares of a company I was holding, but I switched it to just under 1/2 of the shares to be sold in the trailing stop loss order.
    It hit because there was enough of a dip after it climbed. So effectively I locked in a 1.7% gain that happened in 2 1/2 weeks. I’m still holding onto the other shares and they’re up 5%. I now know that I’ll use a simple stop loss order as opposed to the trailing stop loss order.

  10. Greg@ClubThrifty says

    It is always hurts to take your gains too quickly. However, it hurts a lot worse to lose them, IMO. Well done. Also, I love that you included that the rich get really rich during a bull market. I think people often forget this particular nugget: “If I’m wrong, then great. A rising stock market really helps those in the top 20% who own over 90% of stock market wealth.”

    • Financial Samurai says

      It definitely is disappointing to sell too soon. I’ve done this many times before and I expect to do so many times again. I really try and stick to my investment targets and sell and buy when targets are reached. Round tripping investments is the worst and I’ve got a lot that is locked up.

  11. Money Beagle says

    I think you have to keep a close eye on Europe. Over the last couple of years, when news out of Europe comes, it tends to come in a pretty quick wave and that will in turn spook the market. So far it’s been relatively quiet.

    The last couple of years have also paid well for those who sold in May, following the old axiom, sell in May and go away. Last years results didn’t yield for those who stayed out too long, but if you can protect yourself from a decline before another rise, that’s always something to consider.

    • Financial Samurai says

      It’s impressive how sanguine everybody is about Europe now.

      When I took a business trip there last year to study the happiest people on Earth, the conclusion was they were indeed happy and hence BUY. The media was blowing things out of proportion. Now that the media has cried wolf, they are jumping on the bandwagon now. Nice.

  12. William Cowie says

    There’s another reason your 2013 prediction was right on, and may still be conservative: the crashes in the past came “at the right time” i.e. after that particular economic cycle had run its course. If you go back almost a century, you can see we get a recession every 7-10 years, almost like clockwork. (http://bit.ly/economy_chart if you want to see a chart proving that.)

    The 2008 meltdown came 7 years after the 01-02 tech bubble popping. We’re not even 4 years past the last economic cycle bottom, and earnings have barely recovered on publicly traded stocks. We’ve not even hit our stride in the “normal” stock market recovery. What we’re seeing is a new bubble forming, fueled by all that Quantitative Easing which has nowhere else to go. But, even with that the PE on the S&P 500 is nowhere near scary territory yet.

    Therefore, I think we still have at least two more years of appreciation left before we even approach the window of the normal economic cycle turndown. But what do I know? :)

    • Financial Samurai says

      My prediction is definitely looking conservative now, however, too bad we can’t know then what we know now! At the start of the year there were plenty of dire predictions or flat market predictions.

      Confirmation bias is alive and well. However, I do see a return to housing mania which will play out all year. People are feeling quite confident.

  13. John S @ Frugal Rules says

    Good post Sam! That greed really can be tricky to watch and I have seen way too many people in my day lose everything because they were greedy. I don’t know where the market is going, though I like where it is and what it has done to my portfolio this year. I am doing my best to stay the course and not listen to the talking heads on TV but stick to my investment plan.

  14. Mike says

    I think it is essential to make sure that you do the research beforehand. Things have been known to change on a dime, so careful analysis might prevent some headaches when those things do actually change. It’s just something my family has taught me about investing.

  15. retirebyforty says

    Thanks for keeping me grounded. You are a trained economist and doesn’t have any ulterior motive for your recommendations. That’s why I listen to you. I took some profit last week and I need to do more very soon. Our allocation is still a little heavy on the equity side.
    I’ll be happy with 8% for the year. I think we’ll see a downturn this year and I’ll get back in then.

  16. The First Million is the Hardest says

    I think the market will continue to trend higher in the coming months unless the effects of the sequester really hit the economy hard. That being said, I’m a little uneasy about all the good feelings and positive vibes towards the market lately. My plan is to be very cautious with my new money and I’ll probably end up keeping most of it on the sidelines or in different types of investments for the foreseeable future.

  17. Marcel says

    I sold all my investments and took the the gains. Now deciding what to do next. In the meantime, I’ll go sit in the corner . .

  18. Mr. 1500 says

    How do you feel about just buying Berkshire Hathaway and not worrying about it? Seems that Buffett routinely beats the S&P 500. According to his annual letter, he’s beaten it 39 out of 48 years.

    I fret over Buffett’s age, but it seems like he’s lined things up well (also described in the annual letter).

  19. Untemplater says

    I took some profits so I’m going to lay low for a bit and see how things go. I wouldn’t be surprised to see another big correction. So I’m going to probably wait a few more months before thinking about getting back in.

  20. Nick @ ayoungpro.com says

    I handle my issues with fear and greed the same way: I don’t change my investment strategy based on what happens in the market. What I mean to say is that I have a set amount that I invest into a set allocation and I do not change that. Sure, this approach may make me miss out on some “big” deals, but in the long run I feel much better. I am only 28 so I have a long time to be invested in the stock market. Slow and steady is the way for me!

  21. Jose says

    Most of my exits are with trailing stop losses. I typically tighten up the trail (%) as the stock moves up. It doesn’t (and shouldn’t) capture the top but it typically gets me out of a postion a few points ahead of a straight market sell order.

  22. Integrator says

    My approach is a little bit different. The basic philosophy I have is to start with stocks that I would be comfortable holding for years. I then look to sell them if circumstances change, the business isn’t what it was when I first invested. Taking profits is great, but you short change yourself by cashing out of a great investment before you have realized its potential. The investors in Coca Cola who have hung around for years have made millions. They may well have taken some money off the table along the way, but holding on has allowed them to receive more in annual dividends then what they actually invested. I realize stock values will go down at times , thats the nature of the market, but with a dividend paying stock in a quality business, you get paid to hang around and wait.

  23. Ben says

    My theory is to take your stock exposure down to a 50/50 stock/bond (or cash) mix if you are super nervous about the market. You limit your downside without completely getting out of the market and making your decisions based on calendar year numbers. But your situation is different since you are locking in gains for spending needs. Investors can’t just let investments run forever. They need a systematic way to make themselves lock in gains. For long-term investors it’s a good idea to rebalance more frequently to a targeted asset allocation and increase your bond/cash weights when you get nervous and want to lock in gains. A good exercise to get people to think about risk tolerance.

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