By Ben Carlson
(Bloomberg Prophets) --Major stock indexes are hitting new highs almost daily, adding to the huge gains many securities have posted in recent years. For example, Nvidia Corp. has gained almost 1,800 percent since the start of 2013. Over the past five years or so, Netflix is up 1,375 percent; Tesla is up 835 percent; Facebook is up 590 percent, and Amazon has risen 380 percent. Bitcoin is up more than 900 percent in 2017 alone.
If you’ve been fortunate enough to be involved in any of these equities or other market stars, you made the right choice. But investors would be wise to work through their options on how to handle these stocks. Large gains in your portfolio are a good problem to have, but the good news also comes with psychological baggage.
Holding onto gains is better than the alternative, but investors still have to come up with a course of action for dealing with them. Here are some options for those sitting on big winners this year:
Hold on for dear life: The simplest strategy, though probably not the easiest, is to retain your winners and ride out the inevitable storm. Amazon is up close to 40,000 percent since its IPO in 1997. But to get those long-term gains, investors would have had to sit through a drawdown of 20 percent or more in 16 out of Amazon's 20 years as a public company. Bitcoin has fallen in excess of 85 percent three times since 2010.
Pay attention to position sizing: Very few investors have the fortitude to stick with stocks during these types of huge gains and losses. While it’s difficult to stay invested during drawdowns, it can be equally challenging to hold during an uptrend. This is why it can be beneficial for investors to put constraints on their position sizes in a portfolio. Rules for allocation weights to a single holding or fund can guide your actions when markets get out of control. Placing a 5, 10 or 15 percent target weight on any individual position could allow rebalancing every time it runs too hot or too cold. This will help avoid placing too much of your wealth in any one security.
Understand risk: Researchers found that about 11 million 401(k) plan participants invest more than 20 percent of their retirement savings in their employer’s stock. This may seem like a wise decision for those who get in on the ground floor of a successful tech startup, but for every Amazon, there is an Enron that completely wipes out the retirement savings of its employees. About 62 percent of the assets in Enron’s 401(k) plan were in company shares. This much concentration in a single security can lead to unnecessary or avoidable risks. Yes, you can get rich this way, but you can also end up in the poorhouse, and there are far more business failures than success stories in the stock market.
Diversify: The old saying in the money management business is that you get rich through concentrated investing but you stay rich by diversifying. The legendary investor and author Peter Bernstein said, “Diversification is the only rational deployment of our ignorance.” Research shows that the brain activity of an investor making money is indistinguishable from a person who is high on cocaine or morphine. When investors see gains, they need another hit of that dopamine to keep the feeling alive so they begin to take greater risks. Diversification is the way investors can reduce risk by admitting they don’t know what’s going to happen in the future.
Reverse dollar cost average: Dollar cost averaging, or buying a fixed amount of a security on a schedule, is a simple way to diversify across time and market environment. The idea is that no one can perfectly time the markets, so spreading your bets in terms of your cost basis is a good hedge against making an irrational investment. This idea can also work when getting out of or reducing a holding that has grown too large. Investors can manage their emotions by slowly selling down a position so they don’t make a huge move at the wrong time or price.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ben Carlson is director of institutional asset management at Ritholtz Wealth Management. He is the author of "Organizational Alpha: How to Add Value in Institutional Asset Management."
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