Most investors struggle with when to sell or hold their losing positions.  This decision requires considering multiple factors which may include the percent loss, time horizon, tax-loss harvesting and the unpleasant feeling of being wrong.  Given that September is usually a highly volatile month in the Stock market, many investors may be evaluating their greatest losers they want to cut.  In this blog post, we will discuss these factors and how we are approaching this decision for a specific position within our portfolio.

Disclaimer: Please note that the content below are my own opinions and none of it should be interpreted as investment advice.  For investment and tax decisions, please consult your financial advisor and CPA for their recommendations specific to your portfolio.

Individual Stocks vs. Indices

While most professionals recommend index funds and not holding individual positions, every investor is different.  You may hold various positions in your portfolio either to beat the market or because it provides more flexibility that align with your investment objectives (e.g., income goals via high yield dividend stocks or newer income ETFs). Whatever the reason, holding individual stocks are generally much more volatile than index funds and pose greater risk in their ability to recover from steep losses. You are essentially betting on the company’s fundamentals, future potential, and their ability to deliver on performance goals.

Everybody wants to be the next prodigy stock picker, until you are wrong.  What is worse is when your conviction or blind faith leads you to believe that you should continue to dollar cost average on the way down.  What happens if the company’s stock price never recovers from the highs?  This feeling of anxiety is there whether we want to admit it or not.

On the other hand, time-tested index funds with a long history, significant AUM and trading volume (e.g., $VOO or $SPY) are much more likely to recover after a major drawdown. For the S&P 500, history has supported its recovery after most economic downturns. According to MFS Investment Management, the S&P 500 has posted strong long-term gains whether it being 1-year, 5-year or 10-year periods following catastrophic economic events resulting in major drawdowns.

However, it is important that we do not assume that individual stocks or newer index funds have the same resiliency and recovery track record as the S&P 500.  This is a dangerous assumption that can get us into trouble if the positions never recover.

Level of Unrealized Losses

According to J.P. Morgan’s The Agony & The Ecstasy market report, over 40% of all companies in the Russell 3000 index experienced a 70% decline in price from peak levels and have not recovered. This is an eye-opening statistic that emphasizes not only the sheer number of stocks that significantly dropped from their peak but also that they never recovered!  The report further defines this catastrophic loss as those with little recovery with the eventual loss from the peak being 60% or more.

Additionally, it goes on to compare the performance of holding a concentrated position vs. the Russell 3000 as well as the percent of stocks defined as “Megawinners” below:

The key takeaway is simple: the odds are NOT in your favor to own a concentrated position compared to cash and a diversified index fund like the Russell 3000.  In short, the cost of being wrong is far greater than a diversified index fund portfolio!  This is the reason why several investment professionals have recommended the 7-8% rule, to always sell a stock if it falls 7-8% below what you paid to prevent hanging on too long.

So what happens if you hold positions that are down 25%, 50% or 75% from peak?  For each scenario, you would need to achieve a disproportionate higher return just to breakeven below:

The greater the losses, the greater the required return you would need to breakeven. In fact, the required return would need to be exponentially higher further decreasing the likelihood of a full recovery.  Most people make the mistake thinking stocks will always bounce back and its’ more of a question of whether they can wait. The assumption is that if they have a long-time horizon, they will be able to recoup their losses, right? Not necessarily.

This assumption is dangerous for stocks because the odds are not in your favor.  This assumption might be more supported for established index funds, but not for individual companies.  Sure, the recent incredible bounce-back recovery of stocks like TSLA, NVDA, and FB from the bottoms of 2022 has been noteworthy.  However, no one has a crystal ball. The steeper the loss, the less likely of a full recovery.  

Tax-Loss Harvesting

Once you’ve determined which stocks are your losers that you want to cut, you may think the silver lining is that by selling, you’ll reduce your taxes with tax-loss harvesting.  However, the decision to sell should NOT be primarily based on saving taxes. Instead, it should be about your conviction of the business, time horizon and investing opportunity cost.  We need to ask ourselves:

1. Why did I buy this business initially?
2. What catalysts or assumptions changed since opening a position?
3. Does the change affect my reasons for investing in the company?

Additionally, your losses do not translate dollar-for-dollar into your tax savings. Losses are netted against your realized portfolio gains and then your taxes are calculated.

To illustrate the relative tax savings impact, let’s review an overly simplified example of two stocks with the following assumptions:

• Married couple, living in NYC
• $100K investment in Stock A with a 25% loss
• $100K investment in Stock B with a 50% gain
• Both Stock A and Stock B have been held to qualify for long-term capital gains

The first scenario below estimates the taxes for selling both positions for Tax Loss Harvesting. While in the second scenario, the investor chooses only to take profit on the gains and not exercise tax loss harvesting.

The potential tax savings represents ~38% of your realized loss ($9.7K out of the initial $25K loss from Stock A).  While you would still be paying an overall lower tax relative to your tax estimate if you elected NOT to realize your unrealized loss (~$16.9K), the tax savings is not a dollar-for-dollar offset. Note: Consult your CPA and financial advisor to estimate your tax savings from tax loss harvesting.

Revealing My Biggest Loser: Block, Inc.

Block Overview and Investment Thesis

During the pandemic, I purchased a concentrated position in Block ($SQ).  Block is a fintech company that provides hardware and software services for businesses through its point-of-sale payments system (Square) as well as its peer-to-peer payments system in Cash App to consumers. Cash App allows users to send cash, invest, trade bitcoin as well as conduct other financial transactions.  

In December 2022, Block’s revenue consists of ~41% Bitcoin, ~38% Square, ~20% Cash App and ~1% for corporate and other subscription services.  Since Bitcoin represents Block’s #1 revenue source, Block’s stock performance will greatly be influenced by the price and transaction activity of Bitcoin.  

I invested in Block as a long-term holding for the following reasons:

• Resilient core business model (e.g., Square’s seller business ecosystem) and their track record of clients subscribing to multiple software solutions providing them with client “stickiness” and upsell opportunities
• Expansion into multiple ecosystems (consumer, Bitcoin, and creator) and integration between these ecosystems with the traditional seller business (Square)
• Growth of its Cash App payments and future transition into a “cashless” society with expansion into new markets and services (e.g., Buy Now Pay Later)
• Consistent growth in gross payments volume, revenue and gross profit since 2015 while becoming net income positive in 2019 and maintaining positive cash flow through 2021
• Portfolio exposure to bitcoin without directly investing in bitcoin

Block represents only ~0.4% of my total portfolio value.

Position Performance and Breakeven Analysis

While I was up 20-30% in 2021, I regrettably let my emotions and greed get the best of me. I continued buying at the highs until it came crashing down. I am now down 72%. Ouch!  I got burned extremely bad and this was a tough lesson from the market. Over the last two years, there has been a series of negative factors that created the perfect storm of downward pressure on the stock:

• The Fed significantly raised rates hurting overall tech & fintech valuations
• Hindenburg Research published their report of Block inflating its true number of Cash App users (e.g., higher number of fake or duplicative accounts) and lack of regulation of criminal payments on its platform
• Disappointing revenue and earnings performance in 2022 compared to 2021 (e.g., 1% overall revenue decline, 29% decline in Bitcoin revenue, and negative net income)
• Significantly higher operating expenses despite lukewarm future revenue projections, largely attributed to increased product development and general administrative costs

In analyzing the company’s intrinsic value using Ben Graham’s formula, Block’s intrinsic stock price should be around $93 using the consensus EPS estimate for Dec 2025.  With my average weighted acquisition cost being $208 per share, I would need the stock price to 3.5X to breakeven from its current price of ~$58 per share.  While this is likely unachievable in the short-term, Block’s stock price is highly correlated with bitcoin’s price as seen in the chart below:

Given Bitcoin’s price volatility, a 3.5X over the next 5-10 years does not seem unfeasible even though no one can predict the future. Block has always been the “dark horse” in my portfolio for potentially outsized returns or losses.  (At least, this is my argument to my wife who calls it my speculative position.)

Sell or Hold Decision and Rationale

I have decided to continue to hold the position because:

• Limited Downside: I am already down 72%. My mistake was that I purchased during the 2021 fintech bubble and now, the company is more fairly priced relative to historical trends. I do not have much more downside and by holding longer, I’ll likely limit more of my losses. Also, I don’t need the money.
• Company Performance: Block’s financials remain sound. If they had not invested significantly in R&D and maintained a similar amount of revenue as 2021, their 2022 financials would have fared better.  Additionally, the market likely overreacted to Hindenburg’s report. Their claims against Cash App are likely industry-wide issues for all peer-to-peer financial applications and will likely sort itself out in the long-run.
• Future Trends: Block’s strategic decision to invest in bitcoin and blockchain technology as well as connecting multiple emerging ecosystems will likely position it among the leaders in fintech transactions.
• Bitcoin Upside: My initial time horizon was for 10+ years and if we were to assume that Bitcoin’s price is likely to be much higher over the next 5-10 years, Block’s business will likely benefit. As a result, the odds of a positive return on my holdings become more likely.  
• TLH and Opportunity Cost: Since my position is small, the tax savings from tax loss harvesting remains immaterial.  Additionally, there are few alternative investments that are attractive at this time, as the broader indices will likely be choppy so long as the Fed continues to keep rates high through 2024.

Thankfully, I invest most of my wealth in low-cost, S&P 500 index funds, tax-exempt FI funds and real estate. I only have 2% of my entire portfolio in individual positions.  Every investor has its losers and the biggest struggle is knowing at what point to cut bait and sell.    Do you think I’m irrational or level-headed for staying the course?

Final Thoughts

Investing in individual positions is significantly riskier than index funds and depending on the extent of your losses, you may never be able to recover.  When you are evaluating whether to sell your positions, you may want to consider the following:

1. Is this a company that has tremendous staying power, competitive advantage and you are willing to hold for a long-time? (Warren Buffet has often suggested not investing in individual positions unless you are planning to hold companies for 10+ years)
2. Has there been material changes in the company’s fundamentals or future outlook that could impact your investment thesis?
3. Has your position outgrown your target for an individual position within your portfolio? (e.g., does a single position represent more than 2% of your overall portfolio?)
4. Have you set disciplined gain/loss thresholds that support unemotional buying & selling?
5. Do you have a high potential tax bill where your losses can lower your tax burden?

I have found the answers to these questions helpful in guiding me in whether to sell or hold my positions and prevent emotional decision-making.  We hope that you have found the information above helpful. Please exercise caution if you own individual positions and manage your risk accordingly!  

The post Irrational or Composed: How to Know When to Hold appeared first on Stretch My Penny.