Let's say you're holding a lot of SuperCompany's stock. It has been a huge winner, and now it's a major portion of your net worth. It's down with the market, but hasn't been smashed.
You're reluctant to sell, because you'd owe a big capital gains tax. Besides, it's a superstar company. You have confidence in it.
But in this case, holding for the long term isn't the best idea. That advice comes from Sanford C. Bernstein & Co., a New York investment firm, and two of its analysts: Alan Feld, managing director of the family wealth group, and Mark Gordon, director of quantitative research.
When you stake your future on a single company's stock, you run the risk that it -- and you -- will come to grief.
This can be true even with a big-name global business. Of Fortune magazine's 10 "most admired" companies in 1988, only one made the list in 1998 (Merck), and it dropped off in 1999.
Four of those stocks outperformed the market over the decade. The other six did so poorly that investors would have been better off if they'd sold in 1988, paid the tax and bought a mutual fund that followed the S&P; 500 stock index.
In recent years, we've worshipped big-growth companies, especially the high-techs. But of 34 leading tech stocks back in 1980, only one -- Intel -- emerged a winner. Of the rest, 22 aren't trading any more; the other 11 have trailed the S&P; 500 stock average; three of the 11 have lost more than half their value.
Investors who held those stocks might have thought they were playing it safe. But in business, "a lot can change in a short time," says Feld.
This is especially true of highly volatile stocks. All else being equal, the more volatile the price (meaning that it jumps around), the lower its long-term rate of growth.
As an example, the analysts looked at three different stocks, each of them showing the same annual average return over 24 months. Two were volatile, one was steady. The steady stock yielded a higher dollar gain than the two volatile stocks.
That may sound wrong to you, but it's a mathematical truth. Volatility reduces growth. Single stocks are more volatile than the market as a whole. On average, they won't perform as well, over time.
But naturally, you think you don't own an average stock. You own SuperCompany, one of the best.
jv0 But do you remember the dominance of Pan Am (note to younger investors: that was an airline) or Zenith, the electronics power-house? They went from brilliant to broke.
Here's another interesting fact: The longer you plan to hold a stock, the greater the risk that it will underperform.
There are many underperforming stocks, over the long run. The winners are fewer, with little to distinguish them well in advance. Investors weren't picking out Intel back in 1980, Gordon says.
You've read again and again that "buy and hold" is the most prudent course. But that applies to staying in the market as a whole or keeping a well-diversified portfolio. It doesn't apply to any single stock.
Another critical factor is your time horizon. How long you do you have to recoup the tax cost if you sell? Elderly investors might decide to hold. When they die, their heirs will inherit the stock free of capital gains tax.
But taxes may not take as long to recoup as you think. Each situation is different. Assuming that you diversify into the general market, here are some guidelines. If you have a five-year time horizon, consider selling more than half of your SuperCompany stock. If your time is 10 to 20 years, consider selling most of it.
That assumes you're paying at capital gains tax rates (top rate: 20 percent). But what if your net worth is tied up in stock options, of the sort that don't get special tax treatment? If you sold, you'd have to pay ordinary income taxes.
To be prudent, Feld says, you'd still sell at least part of your holdings, and diversify. Options have a time limit. You can't keep them forever. If the stock dives, your net worth could blow away.
The difference between selling options now and selling them three years from now is the timing or your tax payment. There's no guarantee that diversifying will be the best choice, every time. But it puts the odds heavily on your side.