Building Portfolio Wealth: It’s Not What You Make, It’s What You Get to Keep
I won! I won!
The psychological impact of winning and losing is dramatically different.
This little phrase, these two very short words, these four letters—they create such excitement for people. Whether you are the one saying them, or the one hearing them, in most people I won! creates a rush. An adrenaline rush.
What about I lost? What kind of reaction does saying or hearing those two words get? Not a good one. Maybe some sympathy, maybe avoidance, possibly distance and separation. How often do we hear those two words said out loud? Not very often. People don’t like to let others know they’ve lost and the reaction to those two words is often negative.
People loving talking about winning. In investing, that means talking about the stocks you have that went up a lot. Today, there is a good chance that means technology stocks; more specifically the FAANG stocks—Facebook, Amazon, Apple, Netflix and Google (Alphabet)--and their brethren. These are the darlings of today. This is nothing new, though. Throughout the last many years, going all the way back to the year 2000 and even earlier to 1900, people have loved to highlight their winners. But what about the losers? We know they are there, so what about them? Not as fun a conversation.
The investment impact of losing is dramatically different than winning
Let’s talk about the LOSERS. They are many. Many were large, and well-known. I will even go as far as to say many of them were among the largest and best known and most dominant companies and brands in their industries.
Take a look at this snapshot of companies that have filed for bankruptcy over the last few decades:
Source: UCLA LoPucki BRD, as of September 21, 2020.
This is by no means a complete list. Still, it contains almost every major airline. Several of the major automakers. Technology companies. Food makers. Energy companies. Retailers. And more.
Many if not most of these companies were in a position of dominance at their peak, and they eventually went into bankruptcy. In most cases this means the shareholders were wiped out. That is, they received nothing. I certainly don’t want my investments to go down to zero. Do you?
As you look through this list you may say, wait a minute, but this company still exists. Yes, that's true—some of these companies survived bankruptcy … but the shareholder did not. Zero is a real possibility when investing.
Breaking up is hard to do
Ah yes, what do you do and how do you do it. You need to understand there is a big difference between sunk cost and opportunity cost. Present value is different than future value.
With a diversified portfolio, which is what most investors should have, your risks are spread across a number of holdings. This in general will give you better balance between risk and reward.
But with a concentrated portfolio in one or just a few holdings, your risks are much higher. While the reward can be a lot higher too (winning), the risk of ending at zero is also a lot higher (losing).
Take a look at this example. Let’s call this Consumer Technology company XYZ. You start with a $100,000 initial investment in it and watch it grow at a steady pace. Now, it's worth $1 million in your portfolio. But, what do you do now? This is a question you need to ask every day when you hold individual stocks. We know what happened up until now, but we don’t know what will happen next.
You have two major choices: sell it or continue to own it. If you continue to own it and something happens, as it did to the long list of companies above (2020 is proof of the crazy things that can suddenly occur), you could watch the value of this holding drop from $1 million down to $0. Not winning.
Focus on the after-tax benefit—it’s still winning
The other option is to sell your holding XYZ. But wait, I have to pay taxes. I don’t like paying taxes.
I get it, but the alternative could be zero. Let’s walk through an example of how this might work. You start with $100,000 and now have $1 million. Your gain is $900,000. If you assume a 20% tax rate for the long-term capital gain, your tax bill comes in at $180,000. Too often this is where we stop—we get freaked out by the tax bill. Let’s finish the math.
Your investment is worth $1 million at the time of sale. You paid $180,000 in taxes, which means you have $820,000 left in your pocket. Considering your initial investment was $100,000, I would say this is a success story. You are still winning and now you dramatically lowered your concentrated single-stock risk.
Lessons learned and next steps
Now don’t stop there. This is an opportune time to think about two major lessons learned:
- Diversification is important in balancing risk and reward
- Tax management is important to minimize future tax impacts and maximize your after-tax return.
This is as good a time as any to assess where your portfolio is right now. Assess the risks you may have with concentrated stocks. Assume the future could be different than the present—and the present is different than the past. It may be time to lock in those gains, pay the one-time tax bill, and move to a more diversified and risk-balanced portfolio. Again, assuming that we are talking about taxable investment dollars here, we believe strong consideration should be given to using a tax-managed portfolio going forward.
At the end of the day, it’s not what you make—it’s what you get to keep.
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