Posted By 
Marc Bellefeuille, Manulife Wealth
Special to the Financial Independence Hub
In times of market volatility, anything can happen from one quarter to the next. Market participants witnessed a wipeout in the financial markets in Q4 of 2018. The S&P 500 saw its fortunes accumulated throughout the year evaporate from September to November and American stocks suffered the worst declines ever recorded on a December 24thtrading day. Other markets around the world followed suit.
Fast forwarding to Q1 of 2019, the bounce-back for equity markets has been nothing short of impressive. So what can investors take away from the last six months? Certainly, many investors may have questioned those who advise them at the end of 2018, only to be rewarded for having stayed the course in recent months. But what lessons can we learn 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 suggest that a whopping 93.6% of portfolio return volatility is explained by the asset allocation of the investment portfolio1. Nobel prize-winning economist Harry Markowitz called diversification “the only free lunch in finance.”
Yet, more often than not, I see portfolios of bright and capable people concentrated in a few specific positions. The culprit? Capital gains tax. Investors feel at ease 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 a state of concentration of their winners. The idea of paying the taxman keeps them from rationally re-balancing their portfolios which, ironically, can expose them to large shocks during market corrections.
The average market drop in a recessionary bear market is 30.4%.2These kinds of drops often take place without warning – and certainly without mercy – and can drag every sector down with them. These declines can often be more severe to high net-worth investors due to under-diversification of their investments.3
Most high net-worth investors know they should follow a diversified portfolio strategy. However, knowing is only half the battle. Many, when asked, could not explain their strategy for selling positions within their investment portfolios. When pressed, many investors believe 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 averse but when they are, in their minds, playing with house money the rules go out the window and many sit on large gains without re-balancing back to their strategic asset allocation.4
Better off taking profits and rebalancing
One of the impediments to profit taking is the tax bill. Let’s do the math. Assume a successful investor put half a million into the shares of one of the big five Canadian banks in the fall of 2008 and the stock doubled. Were they to sell those shares, as a resident of Ontario, the tax bill would be approximately $133,800: assuming the top marginal tax bracket.
However, let’s imagine 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 amount to $304,000. The investor would have been better off by $170,200 if he had taken the profits and re-balanced the 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 can end up jeopardizing 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 be on our side, which means we often 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. A better question to ask yourself should be “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.
2https://www.cnbc.com/2018/10/26/the-stock-market-loses-13percent-in-a-correction-on-average.html
3https://soundmarkwealth.com/how-much-of-your-wealth-is-tied-up-in-a-single-stock/
4https://www.cpapracticeadvisor.com/accounting-audit/article/12411062/9-ways-to-manage-capital-gains
Marc Bellefeuille has over 17 years of experience in the financial service industry. At Manulife Private Wealth, Marc provides comprehensive, goals-based investment solutions and service tailored to the unique needs of his clients and their families. Each investment portfolio is unique and he builds requirements around each goal, while engaging Tax and Retirement planning and Banking to deliver holistic management to clients. Manulife Private Wealth offers clients the same approach to wealth management that Manulife uses to invest in its own balance sheet.
I like that you wrote about selling non-registered holdings and taxes. I agree that people resist selling or reducing a holding because of taxes. I am one of your “bright and capable” people with a large over-weighting in financial bank stocks. Irrational investor behaviour would be selling a stock after a 10% movement or at the bottom of a bear market. I might regret not selling at high price but if you are a long term investor you don’t sell good stocks in bear markets, you buy more. This means always having some cash reserves through rebalancing and paying taxes. Asset allocation is important but even Markowitz couldn’t follow his own theories due to his fears of regret.