Why sell my stock? It just keeps going up!

At Seaborn, we see a lot of folks come in with high concentrations of a single stock, generally from ESPP's, RSU's, ISO's, or other employee benefits that come in the form of employer stock shares. They look at the immediate past performance, see that the e.g. 20% annualized gain has far outpaced even the S&P500 -- much less a diversified portfolio that includes bonds ("ych -- bonds?!") -- and go "why would I sell my stock?"

Good question. So: let's talk about a mental framework for making that decision. Which, of course, first means talking about cognitive bias.

Hindsight bias and determinism v. probabilism

"I knew that was going to happen." No, you didn't -- but "hindsight bias" makes you think you did. Because the past is deterministic, it fools us into thinking that the future is deterministic as well! (As a software engineer, I was particularly prone to this*, because programs are by nature completely deterministic**!)

And this leads us to try and guess what the future holds with more certainty than is warranted. We take what we think is the most likely outcome and effectively assign it 100% probability -- we focus on "being right". That's how the past works, so we intuitively believe that's how we should think about the future. If our predicted outcome doesn't occur, we assume that we didn't have all the data, hadn't done the proper analysis, etc. In short, we were simply wrong.

Contrast this with thinking probabilistically, in which case you consider each outcome, perhaps assign them a probability, and plan for the fact that either could occur. And if it doesn't go the way you expected, (a) you could have been right, but the dice simply didn't fall in your favor, and (b) you have a plan for addressing that outcome. (At Seaborn, we tend to talk about this in the metaphor of "being the casino": (1) don't make bets you can't afford to lose, and (2) always make bets where the odds are in your favor.)

This is a much more useful way of thinking about finances, not the least because it gives us a whole range of tools to help with analyses. For one, we can take a look at how individual stock positions have fared and use that to determine a possible range of outcomes, and the general likelihood of each. Except we don't have to, of course -- it's already been done for us.

Agony, ecstasy, and catastrophic loss

J.P. Morgan has an excellent article on individual stocks called "The Agony and the Ecstasy", most recently updated in 2021, that reports some very interesting analyses based on 40 years of data (1980-2020).

What's most interesting to me is this: they found that 44% of all companies ever to exist in the Russell 3000 (effectively, the total US public market) experienced a "catastrophic loss", defined as a 70% decline in price from peak that never -- ever -- recovered. For those of us that are/were in the IT sector in particular, that number is actually 59% of all companies.

I want to highlight and underscore this: for any given stock position you own, there is a quite significant chance that it will drop 70% or more permanently!

Contrast that with a diversified portfolio: even in 2008, the reasonably diversified portfolios I've examined dropped by roughly half their stock allocation, and they likely recovered in 3 years or fewer, depending on how aggressively they had been invested. Painful, yes, but not something a robust financial plan can't handle. A permanent 70%+ loss, on the other hand...

Oh, and let's not forget: if this is your current employer we're talking about, then said catastrophic loss would almost certainly be accompanied by layoffs, leading to an ugly one-two punch to both your investments and your income!

But I know my company -- it's not going to fail like that!

First, let me remind you of "familiarity bias" -- we tend to favor what we're exposed to or familiar with to an irrational extent. (No, invest in what you know is not, in fact, good advice!)

Regardless, your faith in your company's management may be well-placed...and management is not, as it turns out, the most common reason why the companies in the "Agony and Ecstasy" study failed. Read the article for a more exhaustive list, but I want to highlight a few:

• Government policy, like tariffs, regulation, and deregulation

• Foreign competition, particularly competition fueled by government subsidies

• Intellectual property infringement

• Patent trolls***

• Fraud by non-executive employees, or acquiring companies, or companies acquired

Two things I want to point out: (1) these are quite common, and (2) they are completely outside of a company's control. Management could make all the right decisions with the information at hand...and they could still get blindsided.

Yes, you could get rich, BUT...

Having said all of that, I want to acknowledge a very important point: you could, in fact, get extremely rich off of a concentrated stock position. The J.P. Morgan article acknowledges this as well, in the spirit of transparency. You may be thinking of Nvidia, which as of this writing has generated 78% annualized returns over the past 10 years, which would have turned $3K into almost $1MM. I understand that it's very difficult not to think "man, I should have known that would happen! If only I'd invested in it earlier..."

That's hindsight bias talking, though. Again: the past is deterministic, but the future isn't. Every investment you make is a bet; don't fool yourself into thinking otherwise. Think probabilistically, not deterministically.

And if you're thinking about Nvidia in particular, I'm old enough to remember Cisco in the late 90's -- another golden child, poised to own the majority of the hardware used to build the very Internet itself. Its stock price tumbled in the early 2000's due to no fault of its own -- Cisco was and remains a well-managed company -- but simply because of a change in expectations for the Internet at large. And that change in expectations isn't because the Internet failed to change the world, as it clearly did, but rather because we finally started to see what that change would and wouldn't look like, and the market adjusted accordingly.

So yes, you could get rich. You could also lose a lot of money, permanently.

A thought exercise

Hopefully I've convinced you that a more probabilistic approach has at least some value. OK -- now what?

First, if you have a single large concentrated stock position that you need to make a decision on, be aware that you can't do the same kind of normal distribution analysis that you can with a diversified portfolio. That kind of statistical approach only works well when you're dealing with Large Numbers; here, rather than a bunch of decisions all with the odds in your favor, you're dealing with one single decision with huge ramifications.

In this case, consider pondering three realistic alternative futures. In one, the stock price soars, and after increasing dramatically in price, you sell the stock and invest in a diversified portfolio. In another, it plummets 70%, and at that point you sell and invest. In the third, you sell and invest now.

Now, this is the important point: in each of those three cases, how is your life different? I don't mean how much money you have; money is just a number. I mean, how are you living differently? What can you do that you weren't doing before -- or, in the second scenario, what are you no longer able to do? Are you able to retire at 30 in scenario 1...or does scenario 2 push your retirement back to 70? Are you willing to take that gamble?

(At this point, I recommend that you resist the urge to assign probabilities to each outcome -- in so doing, you're likely to downplay scenario 2, and as I mentioned before, that's one of the few things that can break even a well-crafted financial plan!)

What's particularly interesting to me is the question behind the question, specifically: what is important to you? Early retirement? Meaningful work? Exotic travel? Relationships? It's not an easy question, but the more you can develop a clear and accurate answer****...well, Steph Bogan is fond of saying "when the vision is clear, the decisions are easy", and she's not wrong.

Specifically, if getting rich quick is really important to some of your "stretch" goals, and if losing a bunch isn't going to break your baseline financial plan, then perhaps speculation could actually make sense.

What are you really looking for?

Fair enough, right? What I've often found, though, is that once we look at the actual results of this thought exercise, clients generally aren't interested in gambling their baseline financial plan. Sure, it would be nice to retire super-early, or improve our standard of living...but not if it risks our current retirement date or spend!

From there, we very quickly discover that the desire to speculate on concentrated stock positions is, for most people, almost entirely emotional. We like seeing numbers go up. Or we've got FOMO because we've seen other folks get rich quick (and hindsight bias prevents us from thinking about alternative scenarios). Or we have an appetite for risk, simply for its own sake. These are all purely emotional reasons, though -- once you look at the analysis and strip out the cognitive bias, though, speculation very often stops making sense.

Does that mean we never speculate? Not necessarily! What it does mean is that we don't let speculation drive the financial plan; instead, we carve out a small but nonzero portion of the portfolio purely to satisfy those emotional itches I mentioned. If it does well, great! "Numbers go brrr", as my kids would say. If it doesn't, your financial plan remains intact. Either way, cognitive bias satisfied, FOMO satisfied, risk appetite satisfied -- and plan undamaged.

Proceed with caution!

Now, you may be thinking, "OK, fine, I'm convinced. Let me just sell all this stock!" Fair enough...but you might want to do some more analysis first! What's the tax bill going to be? Might it make sense to delay at least some of the sales, in particular if there's a potential for a wash sale or short-term capital gains? (Maybe, but maybe not.) If you're looking at more than $1MM, might an exchange fund make sense? Where are the proceeds going to go? How much do you want in cash, and how much in your diversified portfolio? What's the asset allocation of said portfolio?

If you've got ready answers for all of those: excellent! If not, or even if you do but you'd like some help on optimizing, well -- that's what we're here for. We love nerding out about this stuff, whether it's a scenario we've seen dozens of times before or something more on the edge of the bell curve!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

* Yes, even we engineers are subject to cognitive bias.

** Except insofar as they use random numbers...but even those are generally pseudorandom at best!

*** Never have I been so full of rage at work than when I had to take productive time and use it to fight a patent troll.

**** You'd be surprised how many smart people get bored in early retirement!