KEY POINTS:
What better time than the New Year to ditch your dud investments and use the money to buy better ones.
Be it equities, funds, properties or even gold bullion, if it's a dud investment it needs to go. But don't fool yourself by looking at what an investment
used to be worth and how much you've made on it in the past. What matters is what you can expect from the investment in the future.
The hard part is that it can be psychologically difficult to bail out of an investment and realise a real loss rather than sit on a paper one. That's because our reasoning can be clouded by emotion and delusions.
Behavioural finance looks at the psychological mistakes humans make with their finances. When it comes to selling the duds, the "cogitative error" in question is called regret aversion, says Mark Brighouse, vice-president of the Chartered Financial Analysts Society of New Zealand.
"Because people don't want to let go of the possibility that [a dud] might recover or rebound, they hold on to it," says Brighouse. By not selling, investors minimise the pain of being wrong instead of buying an investment with better prospects for growth.
"If the investor could put aside this emotion and concentrate on assessing whether the investment is fundamentally flawed or not then better decisions may result."
Regret aversion is most obvious whenever the property market takes a downturn. In such a climate far fewer properties are put up for sale with owners waiting for prices to go up. How to overcome this, says Brighouse, is to consider what your ideal portfolio would look like for the year and sell off investments that don't fit.
If you have a financial professional managing your money, then this will happen, says Brighouse, whose day job is chief financial officer for Arcus Investment Management. "Professional portfolio managers revisit the investment case for each holding on a regular basis. It is individual investors who don't.
"Justifying an investment to a group of critical peers is a useful decision technique that investment managers use. Conversely some individuals get too enthusiastic about selling just because an investment has had a bad year. But this is not as common as holding on to investments that really need to go.
"People have to be careful," says Brighouse. "If they start selling the dogs of last year, there is still a [chance] of reversion of valuations - providing the situation is not terminal."
Chasing winners too aggressively often doesn't work. In fact some investors have a strategy of buying last year's losers in the belief that swings in sentiment will have undervalued them.
Equity investors also need to be careful that the dud they're ditching isn't going to be a takeover target. Stephen Wright, head of advisory at ASB Stockbrokers, cites Restaurant Brands which as an investment hasn't been great. None-the-less buyers are sniffing around. Getting rid of such a stock too soon could be a mistake.
Wright says he's generally a buy and hold optimist, so he has few equities that he would clear out of portfolios en-masse at the moment. He's cautious about Affco and Rubicon as well as the airline and tourism sectors.
What financial professionals call "rebalancing portfolios" can also involve selling good investments in order to get a balance back into your portfolio. If, for example you believe in spreading your portfolio across a range of investments such as shares, property, fixed interest and so on, and one of those has grown out of proportion to the others, it might be time to sell down that investment and get the balance back into the portfolio.
It is, however, difficult to sell former winning investments. That's especially so when you're sitting on a gain. But just because one investment brought you a fantastic gain last year or the year before, doesn't mean that it's going to have such a good run in 2007.
Selling off the duds doesn't necessarily mean getting out of the markets and keeping the cash in the bank for good deals to come along. In the case of property, many investors who sell down put the profits back into their properties to lower their overall debt. Providing investors' debt to equity ratio isn't too high, they can borrow against existing properties to buy more, says Andrew King, president of the Auckland Property Investors Association.
Over the past year there has been a trend towards sophisticated property investors cashing up less profitable holdings. Auckland-based chartered accountant Garth Melville, whose firm Company Solutions provides accounting and company structure advice to property investors, says while his client base has grown, the number of properties his clients own in total has fallen from around 1500 to 1000.
"People have been selling down the duds and also trading properties rather than buying and holding them."
In some cases investors are selling properties they have found difficult to manage or that have high maintenance. If property market growth continues to flatten and you believe that prices are not going to continue to rise for the next few years then it might be worth getting rid of negatively geared properties - ones where the outgoings are higher than the rent.
The big but when it comes to selling any investment that has gone up in value is that you need to be very careful not to be classed as a trader. We may not in theory have capital gains tax in New Zealand but if you are seen as a trader of property, shares or other investments you are liable to be charged income tax (a pseudo capital gains tax) on your profits.
The litmus test used by Inland Revenue is your intention at the time of acquisition. If that was to buy and hold the investment, you should be safe. But if it was to flick it on for a profit, you could be in trouble. The IRD can also levy income tax on your gains if it sees a pattern in selling that indicates you're a dealer, says John Lowther, chartered accountant and director of Lowthers Tax. "Most of those that get caught are those that buy and sell within a year," says Lowther. He says that investors have also been caught buying property from the plan before it is built, and selling on again before construction finishes.
It is therefore extremely important to document your intentions with every purchase and every sale.
If, for example, you buy a property intending to hold for the long term, you need to document that clearly - for example keeping copies of communications with estate agents and your accountant. If then you find that it has a tinny house next door and is impossible to let, you can sell and hopefully not be hit up for income tax.
Melville cites the case of one client who bought a property intending to hold it, but sold at a profit after he found the presence of a bikie gang in the street made finding tenants difficult. He was able to escape CGT.