Do You Sell Too Early?

At the Fool, we've talked about the benefits of index funds pretty much from the start. That's because over long periods (and many short ones, too), index funds tend to outperform the vast majority of managed mutual funds. (They're also generally much cheaper, and can make investing very simple.)

It's interesting to ponder why index funds do so much better than mutual funds that are carefully managed by thinking people who presumably have some stock-evaluation skills. One reason is simply cost. When an index fund charges 0.25% or less as its annual expense ratio while a managed fund charges, say, 1.25%, the managed fund has to make up a whole percentage point just to catch up.

Another reason is that as fund managers try to outperform the index, they often end up trading too much, lacking the patience to see their initial convictions realized. Even when they're proven right, many managers often sell their winners in order to move money into something else that looks more exciting.

Cutting flowers
In the words of one fund manager, we individual investors tend to "cut the flowers and water the weeds." We may get excited and sell a stock after it doubles, but then it may go on to double and double again, and we lose out on that. Look at these 10-year total returns:

Data: Yahoo! Finance.

For instance, if you'd bought Frontier Oil 10 years ago for about $1.40 per share, you might have sold happily three years later around $4.50, delighted to have tripled your investment. But those who bought a decade ago and hung on ended up increasing their wealth more than 10-fold. The secret here was to not sell -- as long as you maintained faith in the company, of course.

Use your head
Of course, I don't mean to suggest that you should hang on to everything blindly. Sometimes selling is the right thing to do -- or at least, selling some of your shares, to lock in some gain. There are times when a stock simply gets way ahead of itself -- such as Frontier Oil, which despite its gains has lost two-thirds of its value just since last October. Some companies just grow less attractive and lose their edge over time. Hanging on isn't always right.

I lost a lot of unrealized gains back in 2000 because I'd been greedily hanging on to lots of stocks, even though I knew their valuations were unreasonably high. With a stock I'd bought for $5,000 that had grown to $15,000, if I'd sold just a third of it before it fell to $3,000 or $6,000, I'd have recouped my original investment and would have avoided having a net loss. If I'd sold half of my position, I'd have reaped a profit while still remaining invested, to a lesser degree, and able to enjoy possible future profits. In such situations, you need to assess your confidence in the stock's potential and the likelihood that it will advance further.

Back to the index
Alternatively, just put your money in index funds. If you don't want to bother picking individual stocks that might beat the market, remember that you can always just settle for earning the market's average return -- which really isn't settling, since you'll still be outperforming most mutual funds!

Just choose your index fund carefully. Note that they can be really cheap, such as Vanguard's S&P 500 Index (VFINX) fund, with minimum investment of $3,000, a recent dividend yield of about 3%, and an expense ratio of just 0.15%. Vanguard's Total Stock Market Index (VTSMX) fund sports the same minimum and the same fee, but a slightly smaller yield, of 2.7%, due to its holding many smaller, non-dividend-paying companies along with the usual large-cap suspects.

You can get around that $3,000 minimum by opting for exchange-traded funds (ETFs) based on those indexes -- such as the SPDRs (SPY), for example, with an expense ratio of just 0.08%.

So aim to be average or above average, and watch your selling!