THE SCHOOL OF HARD KNOCKS: An expensive lesson to learn in finance by Ron Copley, Ph.D, CFA, LOL contributing writer


Several years ago a gentleman asked me to invest a sizable amount of money for him in a regular brokerage account (non-IRA). He was in his early 50s, earned a very good income, and the investment represented a relatively small portion of his total net worth. He completed a questionnaire to indicate his desire to be aggressive, and I wrote the investment policy statement to reflect his growth objective and high-risk tolerance. We agreed on a strategy of investing in 10 growth stocks based on each stock’s fundamental strength—clean balance sheet, good cash flow, positive earnings, and a few other financial indicators. The gentleman gave me trading authority via a limited power of attorney, which is a normal business practice for most registered investment advisors.
I implemented the strategy by splitting the money evenly among 10 stocks. I had total discretion on how long to hold each security and how to reinvest sale proceeds. The market was booming at the time, and the portfolio performed well over subsequent months. At the end of the first quarter, my evaluation report was really good news. Each holding had generated sizable gains with one stock, a hi-tech company, going through the roof. This stock caused me concern due to the large percentage of the total it represented. The other nine stocks represented 6 to 8 percent of the total, while this hi-tech stock represented 20 percent. Although pleased with these results, I was concerned the big gain in the hi-tech stock could evaporate quickly due to its extreme volatility (high risk).
Even though I had authority to sell the stock without notifying the client, I called him to share my game plan. I was surprised at his reaction. I intended to sell enough of the stock to bring it back to where it once again represented 10 percent of the total—which would mean selling half the position. I would use the proceeds to purchase enough of the other stocks to bring them up to their original 10 percent positions. The end result of the transactions would rebalance the portfolio to its original construction, with each stock representing 10 percent of the total. I thought this was a solid approach and consistent with the policy statement.
My client was thrilled with our results but questioned the tax impact of selling the big gainer. I explained short-term capital gains required paying a tax liability of approximately 40 percent of the gain. The gentleman was upset at this prospect. He was absolutely against paying the tax and inquired about holding the stock long enough (another nine months) to attain a lower long-term rate. I did not like the idea because the hi-tech stock tilted the entire portfolio into a much higher risk category. An argument ensued—and, finally, to compromise, I suggested we sell at least some of the gain, but much less than I initially intended. He reluctantly agreed and I made the transactions.
As the fickle finger of fate had it, within a week the hi-tech stock took a serious nosedive to the point of being delisted from the stock exchange. Basically, it went to zero. The gentleman called me and asked how I knew that would happen. I explained I did not know; I had no idea such devastation would occur. My desire to sell was due to the inherent risk of a volatile stock. His depressing comment at the end of our conversation was he no longer had to worry about paying a big tax bill. Unfortunately, he was right. Instead of incurring a tax liability from a big gain, he incurred a tax loss from the write-off. From that point forward, his attitude toward paying taxes diametrically shifted. He was no longer so adamant about not paying a capital gains tax.
This story is an excellent example of how emotions can interfere with a sound investment strategy. The gentleman’s visceral sensitivity against paying taxes cost him dearly. He should have taken the gain and paid the tax. Instead, he insisted on holding the stock and ended up with a loss. Of course, nobody knew at the time that would happen, but the heightened risk of holding a highly volatile stock for a longer period was known. The emotion he expressed was greed—one of the seven deadly sins.
The importance of this case is in identifying risk as the most crucial factor when managing an investment portfolio. Discipline is the key. A well-defined, disciplined strategy that replaces greed with restraint is the way to transform a deadly sin into a virtue. As the gentleman in this example learned the hard way, allowing taxes to rule an investment strategy can lead to major problems. The lesson we can all learn is to create a thoughtful strategy based on your unique needs and stick to it. Over time, discipline will pay off if the strategy is solid. It is not a complicated equation.
Readers can email Ron Copley comments to [email protected] LOL
Ron Copley is principal of Copley Investment Management, a Registered Investment Adviser in Wilmington. Besides managing money for individuals, retirement plans, and foundations, he conducts business valuations for the legal community and teaches part-time at UNCW.