One of the most challenging aspects of investing is figuring out if you should sell an underperforming investment or whether to hold and be patient.
We’re often told to track investment returns closely and sell investments that aren’t performing. But the reality is, some investments just need more time. Charlie Munger, the legendary investor, famously said, “The big money is not in the buying and the selling but in the waiting.”
So how do you know when to wait it out, and when it’s time to cut your losses and move on?
The premiership isn’t awarded at halftime
Most asset classes typically go through three phases:
- Recovery: This phase happens when an asset class is typically undervalued compared to long-term indicators i.e., all bad news is fully reflected in current prices. Recent past returns tend to have been poor, but the asset’s fundamentals and performance are beginning to improve.
- Expansion: During this phase, the asset class performs well and is starting to become fairly valued. Returns are typically strong, often above average. However, towards the end of this phase, the asset class can become overvalued.
- Downturn/Bust: A shift in economic fundamentals or investor sentiment can trigger a downturn. If the asset class becomes overvalued during the expansion phase, it may experience a significant price drop and poor returns. This can happen due to an economic slowdown, recession, or a shift in investor sentiment.
These phases can last anywhere from a few years to more than a decade. As economist John Maynard Keynes famously said, “The market can remain irrational longer than you can remain solvent.” This highlights that markets can remain irrational much longer than investors might expect or be able to handle financially. Therefore, it’s crucial to never make big bets or take active positions based on the belief that the market is about to boom or bust.
To see returns aligned with the long-term average, investors must be prepared to hold an investment for at least one full cycle. That means if you invest just before a downturn, you may need to hold onto the asset for over 20 years to see decent returns. If you haven’t held an asset through an entire cycle, it’s unrealistic to expect the investment returns you initially hoped for.
Was your original decision fundamentally sound?
When an investment underperforms, the first question you need to ask yourself is: Is this investment fundamentally sound? In other words, does the asset have the core attributes that make it investment-grade? Put aside recent returns and try to put yourself back in the financial position you were in when you made the investment. Looking back now, do you feel it was a mistake?
It’s often easier to explain this with an example. Between 2010 and 2016, many people invested in investment-grade apartments in Melbourne. Unfortunately, since 2010, the median apartment price in Melbourne has only increased by 2.5% per year, which is slightly below inflation, so no real growth. This median figure includes both new and older-style apartments, but many older-style apartments haven’t even achieved that 2.5% annual growth. I’m sure that if investors had known that the market would experience such a prolonged flat period, they wouldn’t have made those investments. But, when you strip that hindsight away, the investment itself was fundamentally sound. These older-style, investment-grade apartments have strong land value, are in highly desirable locations, and have a solid track record of growth prior to 2010. The problem wasn’t with the investment itself; it was the timing.
Sidebar: Some might question whether a house would have been a better investment than an apartment. But this comparison isn’t always fair, because investing in a house would have required a significantly higher budget and higher holdings costs, which may not have been realistic or affordable at the time. This is why it’s important to revisit your original decision based on the financial situation you had when you made the investment.
How long should you wait?
If your original investment decision was fundamentally sound, the best holding period is forever! Some investments just take time. And the longer the market underperforms, the more exuberant the recovery will be.
For instance, the S&P500 index in the US didn’t change between the beginning of 2000 and the end of 2012 – that’s 12 years of no capital growth, only dividend income. However, since the beginning of 2013, the S&P500 index has appreciated at an average rate of 12.3% p.a. – that’s 12 years of above-average performance. If we average that performance over the past 24 years since 2000, the annual growth rate is 5.9% p.a. Together with a dividend yield of circa 2% p.a., that results in an average return of around 8% p.a. which isn’t a terrible outcome.
The Japanese Nikkei 225 stock index is another extreme example. This stock index fell in value for over 22 years between 2000 and 2022. Since 2022, the index has appreciated by almost 12% p.a. and only recently exceeded levels that were reached in year 2000 – that’s essentially 24 years of no capital growth!
This is a perfect example of why Charlie Munger said, “The big money is not in the buying and the selling but in the waiting.”
If the original decision wasn’t fundamentally sound…
If, upon reflection, you determine that the original investment was not fundamentally sound, the next step is to assess how sensitive your investment strategy is to underperformance.
In other words, can you afford to wait for a few years before exiting this subpar investment? For some people, time is a luxury they can’t afford, and the opportunity cost of holding the investment any longer is too high. For instance, if they can’t make new investments until the current one is sold, the opportunity cost can become the most important consideration.
However, if holding onto the investment won’t delay your broader financial plan and you are able to wait, then it’s usually best to strategically divest when the timing is right to maximise your exit value.
Let me give you an example to clarify this. Some of our clients have pre-existing, actively managed investments in emerging markets. As you know, I’m generally not a fan of expensive, actively managed funds. However, right now, it’s not an ideal time to sell, because emerging markets are undervalued. For example, the price-to-earnings (PE) ratios for stocks in Hong Kong and Korea are around 10, while China and Japan are at 15. These figures are significantly lower than the US market’s PE ratio of 25. A PE of 17 to 20 times is considered fair value. Given this, our advice has been to hold onto these investments until the market recovers. Our belief is that we should at least see above-average returns during the recovery phase.
Similarly, if our clients hold direct shares that are not speculative, while we know that index investing is the best, evidence-based approach to invest in share markets, we wouldn’t advise them to sell all their holdings at once. Instead, we recommend gradually and strategically divesting over several years to maximise value.
Patience is virtue
American billionaire and fund manager, Mohnish Pabrai, once said: “The single most important skill for being a good investor is to be very content with not doing anything for extended periods.” In this context, “doing nothing” doesn’t mean being inactive – rather, patience is a critical skill when it comes to investing, especially if the original investment decision was fundamentally sound.
