The Problem with Investment Gains

What to Do When a Minor Asset Suddenly Becomes a Key Player

What do you do when an investment performs beyond your expectations? That might sound like a silly question, but take a moment to think it through: Should you sell it? Hold on to it? Increase your position?

Believe it or not, a significant investment gain, especially one from an unexpected source, can pose a risk to your progress toward long-term goals if it’s not handled appropriately.

Small-Cap Conundrum

Small-cap investors faced the conundrum posed by outsized returns during the early months of the market rally that began in March 2009. Small-cap stocks were outperforming their large-cap brethren — which is not unusual during a recovery that follows an abrupt downturn. During the first six months, they gained 43% compared with 28% growth in large-cap companies (see chart).

A 43% gain in six months is enough to get most people’s attention, especially when their other investments are underperforming. But what would be the smart thing to do with an investment that has performed so well? It depends on your goals and the role the investment was originally playing in your portfolio.

Have Your Goals and Risk Tolerance Changed?

Consider a hypothetical investor whose financial goals, time horizon, and risk tolerance call for only 10% of his portfolio to be in small-cap stocks. Due to an unusual growth spurt, small caps suddenly accounted for 20% of his portfolio because they grew faster than his other investments.

If he holds the small-cap stocks, he may be carrying more risk than is suitable for his situation because he’s become overexposed to one type of asset. (Remember, his strategy called for only 10% in small caps.)

If he buys more, especially if he sells some other type of asset to raise the money, he is chasing performance and ignoring the role that small caps (and the asset he sold) play in his portfolio. If the growth spurt turned out to be unsustainable, the extra risk he assumed could come back to haunt him.

If he sells some of his winners, he’s likely to experience tax consequences, but he could use the proceeds to make additional investments in support of his long-term goals.

Most people would find it difficult to sell shares that have posted large gains. But a decision to sell should depend on what role the assets were playing in the portfolio, rather than on how much the shares had grown in value.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2010 Emerald.