Now that we’re fully in a bear market, it seems to me that one of the biggest challenges for investors is making choices. It’s a bit like a kid in a candy store: almost everything looks tempting, but you can’t buy it all!
Another difficulty is knowing whether a stock that seems to be on sale today will be even more discounted in a few weeks. Is a 20% discount enough to buy, or should we wait for a 25% or 30% discount?
In such a situation, I try to remember two important points.
On the one hand, our portfolios are already fully invested. So, there’s no need to feel rushed to buy for fear that stocks will rebound in the coming days – the eternal “FOMO” (“Fear of missing out”) syndrome. Since our portfolio remains fully invested, it would benefit fully if the markets were to rebound soon.
On the other hand, always – but especially during periods of sharp market declines – my objective is to improve the overall quality of our portfolio, to increase its long-term return potential and/or to reduce its risk. This means that to buy a new stock, we must sell an existing one. If we don’t believe we can buy a stock that’s superior to an existing one in the portfolio, then there’s no reason to make a change. As the saying goes, “don’t trade four quarters for a dollar.” So, if your portfolio is well-diversified and made up of quality companies, the best course of action is probably to do nothing.
If we identify a stock that suddenly becomes attractive after a market correction, we’ll take the time to analyze it in detail – a process that takes several days. Once our analysis and valuation are complete, we’ll compare it to one or two existing portfolio stocks that seem less attractive in terms of quality or risk level.
If the desired stock has greater appreciation potential and an acceptable downside risk, we’ll be ready to make the switch in our portfolios.
To me, the beauty of this discipline lies in the fact that by striving to compare the prospective stock with the least attractive stocks in our portfolio, we largely eliminate the question of when to buy. The only relevant question that remains is: is this new stock more attractive than the least attractive stock in my portfolio?
A Few Other Considerations
The diversification of our portfolio is an important factor to consider before buying a new stock. Our goal is not only to increase the overall quality of our portfolio, but also to promote its diversification. By buying this stock, am I diversifying my portfolio? Or am I increasing a bet on a specific industry?
Another consideration is taxation, particularly regarding capital gains that would be realized by selling a portfolio stock. Every investor’s situation is different, but we might sometimes delay our decision to sell (for example, if we’re approaching the end of a fiscal year). However, we must remember that taxes on gains will be paid sooner or later, and a tax bill should not overly influence a decision that’s beneficial to a portfolio’s long-term performance.
Lastly, in your analysis, don’t forget a bias that could influence your decision to sell a stock: the endowment effect. Indeed, it’s entirely human to attribute more value to an object (or a stock) we already own than to an object we don’t own. For example, it’s easy to attach sentimental value to a company’s stock that has enriched us over the years or to a company we work for. It’s important to keep this bias in mind when comparing the valuations of an existing stock and a new one.
The sharp decline in the markets in recent days is not exactly comforting, but I take solace in remembering that it could offer opportunities we haven’t seen in a long time. But before buying, it’s important to follow a rigorous discipline.
P.S. I wrote this blog before the historic market rebound that occurred in the afternoon of April 9. Although this rebound reduced the number of attractive investment opportunities, I don’t believe it changes the relevance of this blog.
Philippe Le Blanc, CFA, MBA
Chief Investment Officer at COTE 100
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