What a difference a quarter makes. Market participants witnessed a wipe out in financial markets in Q4 of 2018. The S&P 500 saw its fortunes accumulated throughout the year evaporate from September to November and Santa Claus brought but a lump of coal to the stockings of investors as American stocks suffered the worst declines ever recorded on a December 24th trading day in history. Other markets around the world fared no better during this time. It was what we in the business like to call; “A clear example of why investor time horizons need to be for the long term”. Fast forwarding to Q1 of 2019, the bounce back for equity markets has been nothing short of profound. So what should investors have learned over the last 6 months? Certainly, many investors questioned the take on markets from those that advise them at the end of 2018 only to be rewarded having stayed the course in recent months. But what lessons can we take away from recent events and how should we adjust to protect our precious nest eggs in the years to come?

In the famous paper by Brison, Hood and Beebower: “Determinants of Portfolio Performance”, the authors postulate that a whooping 93.6% of portfolio return volatility is explained by the asset allocation of the investment portfolio. [i] Famed Nobel prize winning economist Harry Markowitz called diversification; “the only free lunch in finance”. Yet time and time again I witness portfolios of very capable people concentrated in a few specific positions. The culprit making us play fast and loose with our savings, capital gains tax.  Investors feel endowed by the value they see on their quarterly statements and often feel like they are playing with “house money” so they can justify letting their portfolios drift into concentration of the winners. The idea of paying the tax man keeps them from rational rebalancing of their portfolios which ironically leaves them exposed to large shocks in their portfolios during market corrections. The average market drop in a recessionary bear market is 30.4%. [ii] These kinds of drops occur often without warning and certainly without mercy. They have the tendency to drag every sector down with them. These declines can often be more severe to high net worth investors due to concentration and under diversification of their investments.[iii]

Most high net worth investors know that they should follow a diversified portfolio strategy however knowing is only half the battle. Many when asked could not articulate their sell discipline on the positions within their investment portfolios. When pressed, many investors would be of the opinion, that for any position that declined by more than 10%, they would advocate to hit the sell button and stop the loss. But when a position was up 10% or more the button was harder to push. The greater the gain the harder it gets to take the profits. Investors tend to be loss adverse. But when they are, in their minds, playing with house money the rules go out the window and many sit on large gains without rebalancing back to their strategic asset allocation.[iv] This type of behavior drives economists crazy as it is irrational according to their models. However, we live in a world of humans and not economic models.  One of the impediments to profit taking is the tax bill. So let’s do the math. Assume that a successful investor put half a million into the shares of one of the big 5 Canadian banks in the fall of 2008 and the stock doubled. Were they to divest of the shares as a resident of Ontario the tax bill would be approximately $133,800 assuming the top marginal tax bracket. However, imagine that they decided to hold onto the stock into a future bear market exposing the entire $1 million concentrated position to the average loss. The loss in value would be $304,000. The investor would have been better off by $170,200 taking the profits and rebalancing their portfolio back to their strategic asset allocation. 

Investing across the business cycle requires a strategic and disciplined approach to ensure goals are met. Even when we follow all the rules we cannot say for certain that the outcome is a lock. When the rules are broken, and discipline is lost along the way we potentially jeopardize the prospects of a positive outcome. At the beginning of the cycle when the markets are rebounding from their lows, the probability of further gains can often cause us to hold onto our winners. However, the longer we hold the more we rely on luck rather than logic and rationality in our investment decision making. The question better asked is; Would I still buy this stock today and at this price? If the answer is no, then sell it and pay some taxes. You’ll thank yourself later.

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[i] https://www.cfapubs.org/doi/pdf/10.2469/faj.v51.n1.1869
[ii] https://www.cnbc.com/2018/10/26/the-stock-market-loses-13percent-in-a-correction-on-average.html
[iii] https://soundmarkwealth.com/how-much-of-your-wealth-is-tied-up-in-a-single-stock/
[iv] https://www.cpapracticeadvisor.com/accounting-audit/article/12411062/9-ways-to-manage-capital-gains

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