If there were an easy formula for successful investing, then everyone would be rich. Unfortunately and obviously that is not the case.
It takes time and discipline to build a successful portfolio to meet your investment needs. Sometimes, after critically evaluating your portfolio, you may find that some of your stock positions, while promising at first, simply haven't performed well.
One of the most important things to remember when you find yourself in this position is that you are not alone. But the question remains, what to do now?
When it comes to underperforming stocks, many investors would prefer to simply do nothing rather than take action. This is a natural tendency, because most people have a tremendous aversion to selling stock, often believing that a turnaround is "just around the corner." However, frequently this is flawed thinking and symptomatic of a bigger problem - basing investment decisions on emotions rather than on fundamentals.
Despite the lack of an easy formula, there are a few simple steps investors can follow to take the emotion out of the equation and prune holdings if need be.
Identify underperformers: To make sure your portfolio stays on track to meet your investment goals, identify stocks that have been underperforming relative to the overall market. Remember why you bought the stock, and ask yourself if your rationale for buying is still valid. When a stock's fundamentals change, that could mean that it is no longer appropriate for your individual suitability or objectives.
In addition to analyzing the individual stock itself, it's also important to take a look at its entire sector as well. Sectors move in and out of favor at different times. If you happened to buy a stock in a hot sector when it was at its peak, you may end up waiting a while before the business cycle favors that particular sector again.
After taking a look at your stocks and their respective sectors, you will probably be able to pick out those that could continue to underperform the market for an extended period of time. At this point, you should consider pruning these issues from your portfolio and replacing them with securities that have a more favorable outlook. By regularly identifying and paring losing stocks from your portfolio, you can keep those losing stocks from weighing down your portfolio.
Consider year-end opportunities: Wherever possible, you will want to match any gains you have with losses you may have incurred. For tax purposes, you can offset capital gains you realize over the course of the year with capital losses. If you have more capital losses than capital gains, additional capital losses up to $3,000 may be used to offset ordinary income. What's more, any losses in excess of that amount can be carried over to subsequent years.
Another investment strategy to consider is doubling up. Simply put, you can double your position in a security (as long as you do it at least 31 days in advance) and then sell your original position to claim a loss. This strategy is particularly helpful if you still want to maintain exposure to a particular stock, despite carrying a loss in your current position. Just be careful to avoid the wash sale rule, which also prohibits you from buying back a substantially identical security within 30 calendar days before or after selling one for a loss.
Diversify your holdings: A critical part of managing risk involves owning a number of different investments with counterbalancing characteristics. Your stock investments should be spread over a number of companies in a variety of sectors. For example, no single sector should represent more than one fourth of your portfolio.
Taking a proactive approach to cleaning your portfolio can help put you back on course to meeting your investment objectives.
Adam J. Kennedy is a financial consultant and trust specialist and vice president of investments for A.G. Edwards & Sons located at 1540 Cornerstone Blvd., Suite 110, Daytona Beach. He can be reached at (386) 274-5488.