Since March 2009, the S&P 500 index has risen from a low of 683 to 2,163 as of July 19, 2016. This is a Compound Annual Growth Rate (CAGR) of 16.9%. Over that same time span, Apple has risen 33% CAGR and well established GE has grown at a 23.2% CAGR. The current Bull Market has lasted over 7 years versus the average 4 year Bull run, thus raising the question- is it time to realize some capital gains, or continue to expose your portfolio to risk?
What are Capital gains? These are the profits realized from the sale of an asset. Anytime a gain is realized, there may be tax due (except within an IRA or 401k plan- to be discussed later). The long-term capital gains tax rate varies from 0% up to 20% depending on your income. For many, the thought of paying this tax prevents them from reducing their concentrated equity positions. Investor’s logic can sometimes be distorted when it comes to gains; do I continue to hold this over-weighted position or do I reduce my risk and pay tax? Regret bias becomes a reality as investors find it difficult to give up the record growth they have been receiving over the last several years. As a result, some investors tend to stick with the same equity giving little thought to the down side risk of holding “too much of their hot stock.”
Recently, there have been relatively few investors who refuse to reduce equity exposure even when doing so is tax-free, as within a retirement account. On the other hand, if taking capital gains results in taxes due, many people resist, despite the fact that their portfolios become riskier. The risk arises from what is called stock-specific risk and asset allocation risk. Stock specific risk centers on how a particular stock performs relative to the market, this can lead to both positive and negative outcomes. However, the chance of a negative outcome is greater when holding a few individual stocks versus a fully diversified portfolio. Asset allocation risk can occur when an investor’s risk tolerance varies directly with the performance of the stock market. For example, an investor who held 60% in stocks 7 years ago may now hold 80% or more in stocks, simply because of the performance of the stock market. Making his or her portfolio riskier. The reluctance to reduce equities closer to the original starting point is a result of not wanting to lose out on the gains they have seen historically.
Few investors have benefited from concentrated portfolios. More often than not, investors that hold concentrated positions, experience a very high level of volatility, while the outcome is average performance. In other words, they had a wild ride but got to the same destination a little bit sooner than the average investor. Talk to your financial adviser about a strategy for taking a balanced approach and realizing gains when it is prudent. A plan should be in place for a capital gains budget and estimates of capital gains taxes due, and remember, capital gains tax is the price paid to preserve your wealth.
Contributed by Michael Blatt, CFA. Michael joined Chemung Canal in 1999 as a Research/Portfolio Manager, was elected Assistant Vice President in 2000, and was promoted to Vice President/Senior Investment Officer in 2005. He has more than 20 years in analytical and investment experience. His key responsibilities include recommending and monitoring stocks for the Guidance List in addition to managing client accounts.
For additional guidance, please contact Marci Cartwright at 607-737-3754 or firstname.lastname@example.org.