We spend a lot of time at the end of the year helping clients decide if they should sell some of their securities before the year turns over and if so, then which stocks they should sell.
Many investors are still holding on to losses incurred during the bear market that officially ended in 2003. Some of those are real losses already incurred that are still being carried forward, and some are paper losses that investors haven’t been willing to sell. Either they are still under the impression that their stock will come back or they have gotten emotionally attached to the stock and just can’t let it go. Neither train of thought really makes sense. When you sell a stock for a loss, you can buy it back in 31 days.
In most cases, it’s hard to believe that the stock will rally so much in the next 31 days that it will make up for the advantage of taking the loss on your income tax return. In the other case, my 20 years in the business have shown me that decisions based on emotional attachment are often blindsided by the truth down the road.
Investors look very much like addicts when they are emotionally attached. I well remember a client who lost more than 60% in just over a year in a stock he had owned for over a quarter of a century. When I approached him for the umpteenth time about cutting back his exposure in the stock by taking some losses, he looked me hard in the eye and said, “It pays a good dividend and I’m just not willing to give that up.” He had lost 60% of his market value and wouldn’t sell so he could keep his 4% dividend. And remember, he could buy it back in 31 days.
But I think investors realize that if they ever let go of their underperformers, they won’t buy them back later on. Once you let them go, you have to prove to yourself that it’s a good buy all over again, and in their hearts they know they can’t do that.
I have had very few clients buy back a loser after the allotted time. The fact is it’s not much better with winners.
Most of the time when an investor sells a losing stock, he/she sells it to offset the gain in a winner that he/she wants to sell as well. When you offset the two, you aren’t required to pay the capital gains owed on the stock that had a profit. The good news about winners is that when you sell a stock that has a profit, you are allowed to buy it back the same day if you want to, there is no waiting period. That should make selling a gain to offset a loss something of a no-brainer, but it doesn’t really matter to many investors; they still just can’t part with their favorite stocks.
Some of it is separation anxiety and some of it is just ego.
Investors love to tell their friends, or really anyone who will listen, about how low they got into an investment. Once you sell it and buy it back, your cost basis goes up to the new level. That is a great advantage from the perspective of total return on your portfolio, but it is not so good from the perspective of bragging rights.
And it’s not always bragging to others that matters, in a lot of cases it is an internal thing. Internal bragging rights are a very powerful thing.
This apprehension to sell your winners or your losers leads in many cases to under-diversification of a portfolio and highly concentrated stock positions within a portfolio. That is not always a bad thing; it is, however, always a dangerous thing. Highly concentrated positions in a portfolio can increase the risk in that asset class by three times what it would be if properly diversified. There is no doubt that many wealthy investors have obtained a great deal of their wealth through highly concentrated positions that paid off. The problem is that you can’t expect to maintain your wealth by the same means.
Our business is a business of investments that are continually reverting back to the mean. That means that if you have a stock that has done extremely well, it has a very good chance of under-performing in the future. To protect what you have, you have to be well diversified. No stock is bomb-proof, and you don’t have to look very far back to prove that point.
I don’t have to look further than this past Christmas to understand proper diversification.
My family traveled to Washington State to visit my in-laws. We shipped some presents by UPS, some by the U.S. Postal Service and some we packed in our suitcases. All but one of those shipments made it. If we had shipped them all the same way, we would have had a 66% chance of having all of our presents for Christmas. But what would have been the cost if we had picked the wrong one of the three?
It would have been more than money when we had to tell our little girls that they didn’t get any presents from Mommy and Daddy this year. Instead, we were one of the poor souls shopping on Christmas Eve, but only to replace the few items that didn’t make it. Not a home run, but definitely not a disaster. That’s what diversification is all about.
So, as you go through 2005, try to be objective about what you own and how best you can serve your interests with those investments. If you can’t do it, get some help. It’s one of the best value-added aspects of a good financial advisor and it can make a big difference in how you reach your goals.
Contact MBJ contributing columnist Scott Reed, CIMA, CWA, AIF, of Hilliard Lyons, member NYSE & SIPC, in Tupelo at firstname.lastname@example.org.