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Written by: Peter Mastrantuono
Markets in 2020 took investors on a wild ride, but ended broadly higher for the year. A number of well-known names posted extraordinary gains last year, including Tesla (+743%), Etsy (+302%), Nvidia (+122%) and PayPal (+117%).
Owning individual stocks that experience outsized gains is, of course, something to celebrate, but it also creates a dilemma for investors, i.e., when is it time to take some profits? Conventional Wall Street wisdom is of little help. On the one hand, the axiom of “Let winners ride” suggests that investors should stick with stocks that are working, while another adage, “Pigs get fat and hogs get slaughtered” counsels that getting greedy can backfire when a hot stock reverses direction.
So What’s an Investor to Do?
Most professional money managers regularly review the weight of individual stock holdings in the portfolios they manage since a sharp run up in price can result in an overweighting in that appreciated stock. This overweighting introduces a concentration risk, which portfolio managers often mitigate by reducing their position in that stock to a pre-determined exposure (e.g., 2% of the portfolio). This not only reduces overall portfolio risk, but it instills a sell discipline that realizes the paper gains.
For individuals there are be several reasons why they may want to consider selling a stock that has risen in value, even if they think there is still room for it to go higher.
The first reason is to maintain the investor’s desired portfolio allocation. Most investors develop portfolio allocations based on factors such as return objective, time horizon and the risk they are willing to assume. When an appreciated stock alters the desired portfolio allocation it may introduce a level of risk with which the investor is uncomfortable. In such cases, it may be prudent to take some profits and reduce the exposure to that overweight stock.
Another reason to trim or eliminate a highly appreciated stock position is that the rationale for owning it is less compelling than when originally purchased. For instance, a stock bought a year ago at 35 times earnings may have been reasonably priced given its outlook for earnings growth, but if the company’s shares are now priced at 50 times earnings, it may be more difficult to justify owning it.
A final reason that an investor may want to trim a stock position is because of changes in his or her investment objective. One common scenario is someone who is transitioning from work to retirement. While growth of capital may have been the primary investment objective during his or her accumulation stage, generating income may take a higher priority in retirement.
In such a case, it may make sense to rotate out of high growth stocks that have seen a substantial run up in price and move them into more conservative, dividend-paying stocks (or even into bonds).
There is no formula for when to take profits, and there may be tax consequences to selling. However, many investors find that discussing when and how to harvest profits with an experienced financial advisor can prove valuable to their portfolios and their peace of mind.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.