During 08-09 some of these funds sold off substantially to all time lows/discounts with 20% yields. If an investor were lucky enough to buy them then, should the funds be sold at large profits or held forever? (thinking the NAV may never go that low again and yields may never go that high again). The consensus is sell because once the funds recover you are getting 8-10 years worth of dividends in the profit. However, if you do sell, you are now faced with establishing a new cost basis to provide income during those 8 years that is near impossible to replicate. Thoughts?
Comments
Say you bought a share for $40 that was yielding 20%, and it is now selling for $100, yielding 8% (same $8 interest, just divided by a higher current price).
You've got a $60 gain, whether you choose to realize it or not. You've also got something worth $100. The question you're faced with (again, ignoring taxes) is: where is the best place for that $100?
If you were to buy another bond fund with similar risk (duration, credit quality), it would have a similar yield. If you're happy with your current investment's risk/reward characteristics, keep it - swapping for something else won't accomplish much.
But if you think that you want to get out of the bond market, or get something with shorter duration (expecting rates to increase), they you should consider taking that $100 and buying something shorter term, or cash. (Or if you want to get into equities, go there.)
The point is what I said at the start - you've got the profit now, whether you choose to realize it or not. The choice is not so much whether to sell or not, as it is where you want to put the current value of your investment - where it is now, or somewhere else.
And I emphasize that if there are any tax consequences, they must be taken into account.
Here's a simple math problem to illustrate: Two trains are 100 miles apart, each traveling at 50 MPH. A bee, flying at 100 MPH starts at the first train, flies to the second train, reverses direction until getting back to the first, and so on, until it is squashed between the trains. How far does the bee fly?
One could calculate the sum of the infinite series of flights that the bee makes from one train to another, or one could simply observe that the trains meet in an hour, in which time the 100MPH bee will have traveled 100 miles.
Same idea here. You could calculate how much you'd make with what investments with what trades at what times, or you could simply ask: with the $70K you have now (7000 @ $10), what is the better investment - the fund you're in or a different fund? You could be holding the wrong fund at the wrong time whether that's the fund you currently own or a different fund.
Your numbers do help with this decision. Consider: if your fund is currently yielding 14% ($10K/year on $70K market value), and the alternative funds are currently yielding 8%-10%, what is the market telling you?
>> double your money ever 5 years... At a 20% return per year, you would more than double your money every 4 years
Right; rule of 72 applies fairly closely except at the extremes (annual rate x years = ~72), and if you're unfamiliar with this handy notion, just google.
In the example = ~3.6y for doubling.
The 20% yield was based on a price of $7/share and a dividend of $1.40/year (20%). As stated above, the price now never drops below $10/share, and the dividends (dollar amount) remains fixed "for the foreseeable future".
That means that the best yield one can achieve on the earnings is 14% (reinvesting dividends at a min of $10/share, getting $1.40/share). So while the initial shares continue to yield 20% (based on initial purchase price, disregarding appreciation), compounding occurs at a much lower (blended) rate.
Rule of 72 assumes that returns can be reinvested at the same rate of return. By hypothesis that's not the case here.
I think the area we are ignoring that would have the biggest impact is that if I sold at $17, I would be able to buy more shares (deriving more income) from the new fund purchased although at lower yields, but all of that would be at risk of loss if the share price dropped below my newly established cost basis. The chance of a capital loss at cost basis of $7 is near zero so from a portfolio management standpoint risk is greatly reduced and makes the decision not to sell my $7 investment much more attractive regardless of any compounding calculation. Theoretically, my portfolio value always goes higher although risks always abound.
All that matters is what you have now, and going forward. Capital gain/loss is a tax concept that is irrelevant in a tax-sheltered vehicle.
If you sell, risk is present whether you buy a different fund or the old fund. The latter puts you in the identical position to where you are now.