Where Do Stock Returns Come From?

Peanut butter and jelly. Thelma and Louise. Calvin and Hobbes. Fish and Chips. Wayne and Garth. Some things are better in pairs!

Stock returns consist of two components: dividends and price appreciation. Dividends are paid to shareholders on a quarterly basis from the company’s profits regardless if the stock is up, down or sideways. In addition, investors can profit from price appreciation. Your total return is a combination of the two.

For example, you decide to purchase ABC company at $40 per share. If ABC pays a $1.00 dividend, your current yield will be 2.5% ($1/$40). If you sold your stock at $50, you made 25% ($10/$40). Combining your dividend income with the price appreciation, your total return was 27.5%. If you purchased 1,000 shares, you received $1,000 in income and gained $10,000 giving you a total return of $11,000.

Let’s look at a real-world example. Let’s say you purchased $100,000 worth of Coca-Cola (KO) stock on 8/1/1988 and held it through 8/31/2018. In this example, you generated an annual return of 12.66%. Your $100,000 investment grew to $3.62 million and you received $1.1 million in dividend income. Your dividend income accounted for 31.5% of the total return.

Currently there are 1,269 stocks with a dividend yield of 2% or more. Dividend Aristocrats are companies that have paid, and increased, their dividend for at least 25 years. A few companies on this elite list include: Aflac, Coca-Cola, McDonald’s, Pepsi, Procter & Gamble, Sherwin Williams, Target, and Walmart.

Of course, there are plenty of excellent companies that don’t pay a dividend. Two of the more popular ones are Amazon and Berkshire Hathaway. They plow their profits back into their company rather than pay them to you, the shareholder. In this case, the entire gain comes from price appreciation.  Amazon has generated a 10-year average annual return of 38% while Berkshire has returned 10.5% per year over the same time frame.

The key term to focus on is total return. It doesn’t matter how you make money, so long as you make money.

 two and two, male and female, went into the ark with Noah, as God had commanded Noah. ~ Genesis 7:9

9/12/2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

What’s Your Home Worth – Right Now?

Did you check the price of your home today? Did you get a text on your phone that your home appreciated 5%? Did the commentators on CNBC mention it on TV?

Zillow, and a few other real estate sites, let you check the price of your home daily. When the value rises, do you call your real estate agent to sell it? When it falls in price, do you panic?

The S&P Case/Schiller Index tracks home values across the country. The 12-month return for the 20-city index was 6.31%, the 10-year return was 2.42%. The index fell 20.5% from May 2008 to March 2012.[1]  Did you sell your home because of these price changes? I doubt it. If you’re like most real estate investors, you did nothing.

Home owners are the ultimate buy and hold investors because it’s not easy to move in and out of houses on a regular basis. On a recent trip to Los Angeles I noticed a friends’ home was for sale. He purchased it about 50 years ago for $35,000; it’s currently listed for $850,000. On a gross basis, he generated an average annual return of 6.58% – a decent return. However, if he invested $35,000 in the Investment Company of America mutual fund, he’d have $5.7 million today![2]

Stock investors are obsessed with daily price movements. A tick up, they get excited. A tick down, they get depressed. Stocks are expected to rise so when they fall, investors want to know what’s wrong with the market. Why is it down? Is this the beginning of a correction? Should I sell? Has the market peaked?

Did you know the S&P 500 fell 23% from August 5, 1974 to September 30, 1974? The market lost about a quarter of its value in less than two months and I bet a few investors panicked and sold their stocks. If you apply short-term thinking to long-term problems, you’ll make catastrophic mistakes. The S&P 500 has risen 4,574% since September 30, 1974.[3]

Here are a few suggestions to keep you invested for the long haul.

  • Think generationally. Focus on decades, not days. You may work for 40 years and be retired for another 35. Once you start working and contributing money to your investment accounts, it’s possible you won’t touch your money for 50, 60 or 70 years.
  • Plan. A financial plan will keep you focused on your short and long-term goals. If you know where you’re going, you’re less likely to get distracted by bumps in the road.
  • Buy the dip. The market does fluctuate, so take advantage of down days. Historically, the stock market has risen 73% of the time. When it does drop, use it as an opportunity to buy great companies at discounted prices.
  • Disconnect. TV shows, radio programs and social media sites that report on the stock market cause angst and stir the pot. If you disconnect from TV and social media, you won’t get caught up in the hype. Real estate investors are fortunate because they don’t have to listen to commentator’s pontificate about price movements or stare at a ticker tape scrolling across the bottom of their TV set.
  • Diversify. Purchase several low-cost mutual funds and hold them forever.

Most real estate investors succeed because they think long term and they don’t make thoughtless sell decisions. When they purchase a home, their intent is to own it for several years. Stock investors would be wise to follow their lead. Who cares if the market fluctuates because in the end, it usually wins.

“It fluctuates.” ~ J.P. Morgan

August 30, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

[1] https://us.spindices.com/indices/real-estate/sp-corelogic-case-shiller-20-city-composite-home-price-nsa-index

[2] Morningstar Office Hypothetical Tool – 7/1/1968 to 7/31/2018.

[3] https://finance.yahoo.com/quote/%5EGSPC/history?period1=-630957600&period2=1535518800&interval=1wk&filter=history&frequency=1wk

Losers

The Washington Generals have been playing basketball since 1952. During their tenure they’ve won three games, one in each of the following years – 1954, 1958 and 1971.[1] Despite their lackluster output they repeatedly play in front of sold out crowds at over 450 events per year. Why? It’s because their primary opponent is the Harlem Globetrotters.

The Globetrotters win most of their basketball games and, as a result, the Generals must endure a constant thumping. They are perennial “losers” because of their role, however, they’re really winners because of their long-term association with the Globetrotters.

Some investors are classified as “losers” because they routinely purchase stock at the wrong time. They buy stocks when the market hits an all-time high or just before a correction.

The last three corrections in the stock market have been the Great Recession, The Tech Wreck, and Black Monday. If you invested 100% of your money in the stock market on the eve of these three catastrophic events, how would your portfolio have fared?

The Great Recession occurred from October 2007 to March 2009 and the S&P 500 fell 57%. A $100,000 investment in October 2007 fell to $43,000 in March 2009. If you sold during the dark days of the recession, you would’ve lost 57% of your investment. If you held on, your original investment is now worth $226,000 – a gain of 127%! You generated an average annual return of 7.84% from 2007 to 2018.[2]

The Tech Wreck happened from April 2000 to October 2002. During this rout, the S&P 500 dropped 43%. A $100,000 investment in April 2000 fell to $60,000 by September 2002. You lost 43% if you sold at the bottom.  If you held, your original investment is now worth $263,000 – a gain of 163%.[3]

The stock market crash on October 19, 1987 was frightening. The market fell 22% on Black Monday after falling 4.5% the previous Friday. If you invested $100,000 on Thursday, October 15, 1987, you were down more than 26% by the market close on Monday. After two days of investing you lost $26,000. However, 31 years later, your original investment is now worth $1.64 million. You made 1,543% on your investment, or 9.5% per year![4]

If you happen to be a loser and buy stocks at the wrong time, hang on, because, like the Globetrotters, the stock market usually wins in the end.

“I have never known anyone who could consistently time the market. And in fact, I’ve never known anyone who knows anyone, who was able to consistently time the market.” ~ Burton Malkiel

August 26, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

Photo Credit: Andrey Popov

[1] https://en.wikipedia.org/wiki/Washington_Generals#Beating_the_Harlem_Globetrotters, website accessed 8/28/18.

[2] Morningstar Office Hypothetical – results as of 7/31/2018.

[3] Ibid

[4] Ibid

Los Angeles to New York

The sound of a train whistle piercing the night sky conjures up images of distant lands and the rhythmic clickety-clack of the wheels on the track is therapeutic.

Riding a train from Los Angeles to New York is an exciting way for passengers to see our amazing country. If a passenger boards the train at Union Station, they’ll arrive at Grand Central in about three and a half days.

Travelling by train is mostly hassle free, but at times it can be frustrating. For example, when the train is going slow or stopped, passengers can become anxious. Some passengers may disembark from the train to explore alternative forms of travel such as a car or plane. If a passenger discards his plan, he might not reach New York. However, if he stays on the train he’ll arrive at his desired destination.

When the train is travelling fast, don’t get too excited. When it’s travelling slow, don’t get overly depressed. When it’s stopped, don’t abandon your trip.

Investing has a lot of similarities to riding a train. In short, if you stay with your plan, you’ll arrive at your destination. If you make too many changes, your plan may get derailed. Investors in a diversified portfolio may own investments going fast, slow or stopped. The urge to reduce your holdings in non-performing assets and purchase better performing ones may be high, but this strategy is not recommended.

The world markets are giving us a mixed bag of results so far. Large-cap growth stocks have risen 10.75% and micro-cap stocks have climbed 11%. International investments, emerging markets, and bonds are down for the year.

What makes for a successful trip? The first component is to select a destination. Once you’ve identified your location, you can complete the rest of the travel process. When will you leave? What will you pack? What train will you take?

A successful investor, like our traveler, needs a destination. Financial goals are paramount if you want to succeed as an investor. Do you want to retire early? Buy a vacation home? Travel the world? Start a business? Once your goals are identified, your financial plan can help you quantify and prioritize them.

You need to commit to your goals for the duration. Jumping in and out of the market because it fluctuates is not wise. If you reject your plan before your goals are reached, you may derail it forever.

The market constantly goes up, down and sideways so don’t abandon your long-term plan because of short-term market moves. All aboard!

There’s something about the sound of a train that’s very romantic and nostalgic and hopeful. ~ Paul Simon

August 26, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

Sears or Turkey?

Every now and then a small country seeps its way into our financial engine. A few years ago, it was Greece, today it’s Turkey. Turkey is in crisis with the Lira falling 30% and its stock market dropping 17%.[1] The Turkey ETF (TUR) is down 50% for the year and it is inflicting havoc on emerging markets despite accounting for less than 1% of the index.

Turkey’s stock market has always been volatile. From 1998 to 2017 it generated an average annual return of 22.89%. The range, however, has been wide. In 1999 it rose 252% and fell 62% in 2008. Investors who commit capital to this market must be bold and courageous.

As an American investor should you be concerned about Turkey? I don’t think there’s much risk as most individuals only allocate a small percentage of their holdings to emerging markets. A bigger concern for Americans should have been the downfall of Sears, Roebuck & Co., and if we can survive a crisis in Sears, we can certainly survive one in Turkey.

In 1969 Sears Roebuck was the largest retailer in the world, employing over 300,000 people. We relied on Sears for almost everything because they carried almost everything. Their massive catalog offered thousands of items from underwear to log cabins. Their real estate footprint was massive and in 1973 the Sears Tower was completed. It was one of the largest buildings in the world, fitting for a gigantic company like Sears. A visit to the Sears store was an event. You could drop off your car at their auto-center and stroll their store aisles munching on their tasty popcorn.

Sears had 555 stores at the end of April 2018. In May the announced they were closing 72 stores, followed by another 78 in June.[2] In 2005 they had 3,500 locations.

Sears housed iconic brands like Kenmore, Craftsman, Dean Witter, Coldwell Banker, and Discover. In 1984 it launched Prodigy with IBM and CBS. Prodigy was an early precursor to the internet and it offered email and games.[3] They were on the front lines of all things new.

Sears stock was once a juggernaut. It was part of the Nifty-Fifty, a group of stocks that were never expected to fall in price. They were considered one-way trades in the ‘70s. In 1998 Sears had a market cap of $22.5 billion. Today it’s $206 million, a drop of 99%.  The current stock price for Sears Holdings is $1.90 and Morningstar classifies its stock as distressed.

Turkey and Sears are where they are today because of poor financial decisions and hubris. Unlike Turkey, Sears was a major player in our markets and a member of most indices, including the Dow Jones Industrial Average. If you’ve been a long-term investor, it’s likely you had substantial exposure to Sears stock without knowing it.

If you survived Sears, you’ll survive Turkey.

My dad’s idea of a good time is to go to Sears and walk around. ~ Jay Leno

August 11, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

Photo Credit: Brunomili

[1] https://www.bbc.com/news/business-45113472, Andrew Walker, 8/9/18

[2] https://en.wikipedia.org/wiki/Sears

[3] https://www.techrepublic.com/blog/classics-rock/prodigy-the-pre-internet-online-service-that-didnt-live-up-to-its-name/, Michael Banks, 12/18/2008

The Wolfpack

The wolf was eradicated from Yellowstone during the 1930s. They weren’t protected in the national park because they’re predators and, as result, there were no wolves left to maintain order. At first, there was little change to the ecosystem, but over time it changed dramatically. With one less predator to worry about, the elk taxed the park’s food chain by eating flora and fauna. Their devastation of the park led to erosion and other unintended consequences.

The campaign to reintroduce the wolf back into Yellowstone started in the 1940s by a gentleman named Adolph Murie. He wrote a report based on his study of the wolf titled: Ecology of the Coyote in the Yellowstone National Park.[1] His work started a movement to restore order in the park. It took 55 years, but the wolf finally returned to Yellowstone as 14 wolves from Canada were captured and moved to their new home.[2]  In 2016 there were 108 wolves in 11 different packs.

After the wolves became acclimated to their new home, the ecosystem started to return to normal. The elk population had been culled and they now roam the park to avoid being eaten. Their movement has allowed willows and meadows to return to their former glory. The additional growth has allowed the beaver population to flourish.  Prior to the return of the wolf, there were few beaver dens, today there are hundreds. The beaver dens have also benefited the fish in the river.[3] Yellowstone looks amazing, but it’s still evolving, and the full restoration won’t be known for decades.

Investors live in a financial ecosystem.  As the park needs the wolf to maintain order, investors need a balanced portfolio. If you remove a key component from your portfolio, it may cause long-term unintended consequences to your wealth.

Stocks are the alpha-investment for your portfolio and there’s no greater security to own if you want to create wealth. Of course, stocks are volatile, irrational and erratic. Because of this behavior, it might be difficult for investors to hold stocks through good times and bad. However, to capture long-term returns from stocks it’s necessary to employ a buy and hold strategy.

The average annual return for stocks, dating back to 1926, has been 10.2% per year. This exceptional growth rate has allowed individuals to increase their assets and outpace inflation. Inflation has averaged 2.9% for the past 91 years so failure to own stocks will erode your purchasing power.

In addition to their exceptional growth, stocks also provide an income stream through dividends. Dividends have historically accounted for about 42% of the total return.[4]

International Investments expose you to 48% of the world’s stocks domiciled outside our borders.  A global portfolio gives you access to thousands of companies with headquarters in Europe, Asia, and Latin America.  Since 1998, the U.S. has never held the top spot for the best performing stock market. The U.S. stock market gained 21% last year, underperforming 31 countries.

Bonds are desirable for income and safety. Adding them to your account will reduce your risk level and provide you security during a market stampede. During the 2008 correction, long-term U.S. bonds rose 25% and during the Tech Wreck they soared 43%. Yes, interest rates are low, and the Federal Reserve has been raising rates, but bonds are still a must own item if you want to maintain a balanced portfolio. From 1926 to 2017 bonds produced an average annual return of 5.5%.

Cash is required for liquidity. A cash position allows your other investments to grow or produce income. If the market does pullback, you can rely on your cash position to meet your short-term needs.

To maintain order, invest in a globally diverse portfolio. Stocks, bonds and cash produce an ecosystem that work in harmony for your benefit. It might not be evidently clear what happens to your portfolio when you remove one of the key components, but over time it will become obvious.

For the strength of the Pack is the Wolf, and the strength of the Wolf is the Pack.” ~ Rudyard Kipling, The Jungle Book.


August 9, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. 

[1] https://en.wikipedia.org/wiki/History_of_wolves_in_Yellowstone

[2] Ibid

[3] https://www.nps.gov/yell/learn/nature/beaver.htm

[4] https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf

4 x 100

The 4 x 100 relay race is one of the most exciting spectacles in all sports. Four extremely fast human beings pass a baton with precision as they speed around the track. The current world record is held by Jamaica, anchored by Usain Bolt, with a blistering time of 36.84 seconds.

The collective four are faster than any one person can run the 400 meters. The world record for the men’s 400 is held by Wayde van Niekerk of South Africa with a time of 43.03 seconds, a full 6.19 seconds slower than the Jamaican relay team. Six seconds is an eternity in track in field.

When a relay team runs the 4 x 100 three quarters of the runners are standing around doing nothing as they wait for the baton. Three of the runners are idle like a plane resting on a tarmac waiting to take off.  Nevertheless, all four runners are needed at some point during the race to win and produce lightning like results.

Investors can learn a thing or two from a relay team. For example, in a diversified portfolio you may have one or two investments doing well while the remainder of your holdings are idle. For the past few years the winning trade has been growth stocks, specifically technology stocks like Amazon and Apple. Value stocks, international investments and bonds have trailed the high-flying growth sector. Does this mean you should abandon your diversification strategy and move your money to growth stocks? It does not.

As I mentioned, the relay team produced better results than the individual runner. You may get lucky by picking an occasional winner, but over time a globally diversified portfolio is tough to beat.  It’s hard to argue with the performance of Amazon’s stock price over the years. Year to date it’s up 51.99% and this follows last year’s gain of 55.96%. However, there have been periods when it has trailed the S&P 500 – hard to believe, but true.  Amazon failed to beat the index in 2016, 2014, 2011 and 2008.  During the Tech Wreck, Amazon fell 79.5% in 2000 underperforming the benchmark by 70%![1]

Berkshire Hathaway is led by the greatest investor of all-time, Warren Buffett, but it occasionally underperforms the popular index. It failed to outperform the S&P 500 in 2016, 2014, 2013, 2012 and 2010.[2]

The S&P 500 is not immune to poor performance. From 2000 to 2010 it generated an average annual return of .4% while long-term government bonds returned 7.9% per year, real-estate holdings rose 11.9%, emerging markets climbed 10.9%, and global stocks returned 2.7%.[3]

Growth stocks have been outperforming value stocks for some time, but during the month of July value stocks outperformed the growth sector.  Is the baton being passed from growth to value? Who knows. Unlike a relay team, there is no coordinated handoff between asset classes. It’s impossible to know when one category will outperform another, so the best strategy to employ is to own a globally diversified portfolio of low cost mutual funds because you never know when an asset class is going to carry the baton for the rest of your portfolio.

Remember, it’s not how you start but how you finish.

There are better starters than me but I’m a strong finisher. ~ Usain Bolt

August 6, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.

[1] Morningstar Office Hypothetical Tool

[2] Berkshire Hathaway 2017 Annual Report

[3] Dimensional Fund Advisor’s 2018 Matrix Book

When to Sell A Stock?

A few high-flying growth stocks came crashing back to earth after posting poor earnings. Facebook fell 21%, Netflix dropped 19%, and Twitter cratered 27%.  In the days leading up to the Facebook announcement, it rose 4.5% to close at an all-time high of $218.62. If investors knew it was going to collapse, they would’ve shorted the stock or bought puts to profit from the drop.

Facebook went public in May 2012 at $38 per share. It has returned 354% for investors, or 27.5% per year from its initial public offering. However, after a few days of trading it fell 25% and by Labor Day it had dropped more than 50%. In Fact, Barron’s Magazine gave it a thumb’s down in their September 24, 2012 issue with a price target of $15.[1] It never hit $15 per share and since the article appeared Facebook has risen 1,050%!

Facebook has had double digit losses in each year it has been a publicly traded company. If you sold it on every wiggle, twitch, or flutter, you’d never make any money. A buy and hold investor has probably made the most money in this stock if she’s been able to ignore the volatility.

As a stock gyrates, how do you know if it’s the beginning of the end or a temporary pause in an upward trend? How do you know when it’s the right time to sell?  Here are a few suggestions.

Allocation. If your single stock holding is more than 25% of your portfolio, it’s a good time to sell and diversify your assets. A 3% to 5% allocation to a single stock is recommended.

Price Target. If your stock hits your pre-determined price target, take your gain. If you buy a company at $15 per share with a price target of $20, take your profits if it trades to your mark.

Ratios. A rising stock is fun to own. As it climbs, keep an eye on the key ratios like price to earnings, price to sales, and price to book. The higher the level of the ratios, the lower the future performance of your stock may be. Comparing current and historical ratios is advised. You can view this data in Morningstar, Value Line, or Yahoo! Finance.  Netflix stock price soared 126% in less than a year and despite the recent 20% drop, it still trades at a price to earnings ratio of 125, well above historical norms.

Balance Sheet.  A company with negative cash flows or high debt levels should be avoided. If it’s cutting or eliminating its dividend, it’s a good candidate to sell. Tesla has been a polarizing stock for a decade and since 2008 it has had (growing) negative cash flows.

Goals. Your financial goals may change over time. If your account value has increased and you want to preserve your assets, sell some of your stock holdings and buy bonds. This will reduce your stock exposure and risk level.

Taxes. If you have realized gains, sell stocks with a loss to offset the gains. If you have realized losses, take gains. You can offset gains and losses dollar for dollar.

Timing. Selling a stock at an all-time high is always preferred. However, it’s better to buy at the right price, but this is hard to do because the stock is probably in a slumber or hitting new lows. The best time to have bought Facebook was September 4, 2012 at $17.73 after it had fallen 53%. Obvious today, but it would’ve been a difficult purchase at the time because it was engulfed in negative news as evident by the Barron’s article. It was also a new platform not known to many. If you have the courage to buy a stock that everyone hates, you may be rewarded over time.

A strategy I recommend is to purchase a basket of low-cost mutual funds giving you exposure to thousands of companies. A globally diversified portfolio of mutual funds will free you from making any buy and sell decisions allowing you to focus on your long-term goals.

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets. ~ Peter Lynch


August 1, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. Please consult your CPA or tax advisor before implementing any of these strategies to see if it makes sense for your situation.

[1] https://www.barrons.com/articles/SB50001424053111904706204578002652028814658, Andrew Bary, 9/24/2012.

What to Do with A Capital Gain?

The bull run continues. The Dow Jones has risen 292% from the abyss in 2009, and it’s now the longest running bull market in stock market history. The move has produced some monster capital gains and it’s possible you may be sitting on a few stocks with large profits. What can you do if you own a portfolio full of profits?

Let’s look at a few ideas you can employ if you own stocks or funds with large capital gains in a taxable account.

Hold. If you have gains, you don’t have to do anything. Holding on to existing positions allows you to defer gains and taxes for as long as you want. If you still believe in your holdings, let your profits run.

Family. You can give your shares to your children, but you won’t get a tax deduction. It will reduce your estate and increase theirs. Your children will inherit your cost basis.

Charity. Donating your shares directly to a charity will allow you to deduct the contribution from your taxes at fair market value. The charity will benefit because they can sell your shares free of taxation and use the proceeds to fund their cause.

Donor Advised Fund (DAF). A Donor Advised Fund allows you to transfer appreciated shares to this instrument. Once inside the DAF, you can sell your existing shares and purchase new investments without realizing a capital gain. You can deduct the contribution from your taxes and then distribute the proceeds to charities you support. The deduction from your taxes occurs in the year of contribution, not in the year of distribution. You don’t have to distribute the proceeds immediately, so if you’re not sure which charities to support you can defer payment until you identify organizations you want to help. For example, if you transfer $100,000 worth of Amazon stock to your Donor Advised Fund you can sell it and reinvest the proceeds, and then send a portion of the money to your favorite charity. The funds inside your DAF will continue to grow tax-free.

Call Options. A call option replacement strategy allows you to sell your equity shares and purchase a corresponding share amount in the form of a call option. The ratio is 100 shares to 1 option. If you own 1,000 shares, you can purchase 10 option contracts. This strategy allows you to sell your stock position but retain ownership in the company at a reduced amount.  For example, 1,000 shares of Amazon is currently worth $1.86 million. The January 2019 $1,860 strike price has a current price of $162 per contract, so 10 contracts costs $162,000 (10 x 100 x 162). The contract value is about 10% of the market value of the common stock. If you sold your shares, you can use a small percentage of the proceeds to buy the option and diversify the remainder. The downside for this strategy is that you’ll pay tax when you sell your shares. Another disadvantage is the call option has a finite life, it will expire on January 18, 2019. If Amazon is trading above $1,860 at the time of expiration, the call option will finish in the money and you can take your gains. If Amazon is trading below $1,860, your option will expire worthless and you’ll lose 100% of your money.

Put Options. If you want to hold your shares, but you’re concerned about a drop in the price, you can purchase a put option. A put option will increase in value when a stock falls. It’s short term insurance against a market decline. This strategy allows you to retain your stock, but at a price. Insuring your position will get expensive, especially if you repeat the process a few times a year. For example, the January 2019 $1,860 strike price is currently $135. Protecting 1,000 shares will cost you $135,000. If Amazon falls below the $1,860 strike price at expiration, you’ll make money. If Amazon closes above $1,860, you’ll lose 100% of your proceeds.

Charitable Remainder Trust (CRT). This trust allows you to transfer your shares to a CRT, sell your holdings, and receive income from the proceeds. At your death the remainder of the trust is delivered to a pre-determined charity. The stock, once transferred, can be sold free of taxation and then you can reinvest the proceeds into a diversified portfolio of stocks or funds.  Your contribution to the trust qualifies for a charitable deduction. The amount of income you may receive from the trust is between 5% and 8% of the portfolio value.

Exchange Fund. As the name implies, you exchange your current shares into a fund to receive shares in a basket of stocks. This will allow you to defer your gains. The minimum is steep, and you’re required to hold the fund for several years.  In addition, 20% of the fund assets must be held in non-investment assets like real estate which may hinder your liquidity efforts. According to a Forbes article on exchange funds, the minimum investment for some funds is $5 million with a required holding period of seven years. This strategy is best suited for individuals who own concentrated stock positions.[1]

Private Annuity. This is a popular strategy that can benefit you and your favorite charity.  The private annuity works well with colleges and universities. If you donate your stock to your alma mater, they can establish a private annuity for you, so you can receive income for life. Your alma mater can sell the stock free of taxation and use it to fund their operations. You’ll get a deduction and an income stream.

The only difference between death and taxes is that death doesn’t get worse every time Congress meets. ~ Will Rogers

July 25, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

 

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. Options involve risk and are not suitable for every investor. Please consult your CPA or tax advisor before implementing any of these strategies to see if it makes sense for your situation.

 

 

 

[1] https://www.forbes.com/sites/agoodman/2016/01/10/one-way-some-wealthy-investors-can-avoid-big-capital-gains-taxes/#1680ec4f324e, Andrew Goodman, 1/10/2016

10%

Ten percent has been the average annual return for the S&P 500 since 1926. One dollar invested in 1926 grew to $7,347 by the end of 2017.[1]  Because of the 91-year average most investors expect (demand) a 10% return every year. In fact, when analysts give their stock market return projections for the coming year the answer is usually 10%. It’s a safe prediction because of the history of the index.

Despite the historical average annual return, the index has never closed at 10%. The closest it came to the average was 2004 when it returned 10.9%.

The road to average is paved with euphoria and despair. From 1982 to 1999 the index averaged 18.5% per year. From 2000 to 2012 it returned a paltry .6% per year. The best one-year return, after World War II, was 1954 when it soared 52.6%. The worst year occurred in 2008, plummeting 37%.[2]

During the Great Depression the market fell 85% and because of the Oil Embargo of the ‘70s it dropped 41%.  It declined 43% throughout the Tech Wreck and 37% amid the Great Recession.

To date, the S&P 500 is up 4.64%. It started the year at 2,695 and by the end of January it had already risen 6.5%. The gains didn’t last long as the market rolled over in February, falling 10% from its all-time high.  From the low of 2,581 it has rallied back to its current level of 2,820.

Most investors don’t allocate 100% of their assets to a single fund or index. A diversified portfolio is the norm but some question whether it’s better to concentrate or diversify. To create wealth, concentrate your holdings and to preserve it, diversify.

Concentration in technology stocks is working well in 2018. A portfolio of FANGs – Facebook, Amazon, Apple, Netflix and Google (now Alphabet) is up 35%. A diversified portfolio of large, small, and international mutual funds mixed in with some bonds is up a measly .81%.[3]

I know these results all too well as my daughter’s account is soaring due to a few of the FANGs, one of which she’s owned for more than 17 years. My account, on the other hand, is well diversified and it’s flat for the year.

As we venture into the second half of the trading year focus more on your long-term goals and less on stock market averages. The market has delivered exceptional returns for decades and the future will be similar. Of course, some years it will rise and others it will fall. As it rises don’t get overly excited or too depressed when it falls. In the long run, a well-diversified portfolio will deliver you market returns and if you capture them you’ll do better than most investors.

I’m optimistic on the future of the market – stay invested my friends!

It’s a wonderful thing to be optimistic. It keeps you healthy and it keeps you resilient. ~ Daniel Kahneman

July 25, 2018

Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.

Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. 

[1] Dimensional Fund Advisors 2018 Matrix Book

[2] Ibid

[3] Morningstar Office Hypothetical Tool. The diversified portfolio consists of VOO, VB, VXUS and BND.