In October 2018, I bought $55,000 worth of Tesla stock, at $298 per share. When the stock reached about $888 per share on June 5, 2020, I decided to sell 70% of my holdings. I just couldn’t take the volatility anymore.
I’m now up a little over $100,000 on my position. But if I had held onto my entire stake, I’d have up to $250,000. Who could have predicted that Tesla would exceed $2,000 per share — let alone during a global pandemic, when automobile spending is way down?
Missing out on more than $150,000 in Tesla gains was quite painful, but it taught me some valuable lessons about buying individual stocks:
1. You can’t outperform the S&P 500 if you only buy the S&P 500.
Investing in index funds has grown in popularity due to its low fees and exposure to a diverse range of companies. There’s also a growing realization that it’s very hard to outperform the S&P 500 or other stock indices over the long run.
As shown in the chart below, the vast majority of active equity funds have underperformed their respective benchmarks over a 10-year period:
In order to get rich faster than the average person who invests only in index funds, you must take calculated risks — by investing in individual stocks that you believe will outperform the S&P 500.
Since most professional equity fund managers underperform their respective indices, a smart move would be to allocate a small percentage of your investable equity allocation in individual stocks.
I try to invest anywhere between 10% to 20%. But it’s up to each person to determine their own amount, depending on their risk tolerance, goals and experience. As the saying goes, “No risk, no reward.”
2. Take into consideration your capital gains tax rate.
Short-term capital gains are gains you make from selling assets you hold for one year or less, and they’re taxed like regular income. Long-term capital gains are gains on assets you hold for more than one year. They’re taxed at lower rates than short-term capital gains.
So when deciding whether to sell or hold, you must calculate two things: the tax implication between your short-term and long-term tax rates, and what stock return assumptions are required at different tax rates in order to walk away with the highest returns.
Let’s say your salary is $100,000, and a stock you bought for $10 nine months earlier has appreciated to $15. If you sell it now, you’ll earn $5, minus 24% for federal income taxes. Your net return is $3.80. But if you hold for at least 12 months and then sell, your net return is $4.25. You can now calculate your downside buffer for the cost of holding for at least 12 months.
Here are the short-term and long-term capital gains tax rates this year (for singles):
3. Turn your ‘funny money’ into real assets.
I call any type of unexpected financial windfall (or faster-than-expected investment gains) “funny money.” A good example would be my Tesla profits, because I decided to buy the stock on a whim after hearing a friend crow on and on about how much he loved his new Model 3.
In retrospect, I feel like an idiot for having sold my shares. Still, instead using my gains to buy more stock, I turned them into real assets.
Never forget that the whole point of investing is to eventually use the profits to buy a better life. If you wait until the traditional retirement age of 60 (or older), you may not get the chance to truly maximize your lifestyle. If the coronavirus pandemic has taught us anything, it’s that tomorrow is never guaranteed. If you die with lots of money, you lose.
I’ve used funny money to pay for a new hot tub, nice shoes for my kids and to build a deck off my main bathroom. And since real estate figures are lagging the stock market, I’m planning to buy another home in San Francisco. Although the S&P 500 has continued to go up over the years, I’ve never regretted any of my purchases.
4. Don’t confuse brains with a bull market.
I worked in finance during the dotcom bubble burst. Many people I knew lost all their gains. Some even incurred heavy losses due to buying stocks on margin. People were quitting their jobs left and right to do online stock investing.
When times are good, or when there’s maximum investing FOMO (fear of missing out), we tend to get overconfident, and our risk parameters get out of balance. The result? A tendency to invest more money than we’re truly comfortable with losing.
Building sustainable, long-term wealth is all about having the appropriate risk parameters in place. Once you start believing you’re the next Warren Buffet, you run the risk of financial ruin.
5. Always think in probabilities.
No investment is guaranteed, so it’s important to always calculate the probability of your decision leading to a good or bad outcome.
For example, I think there’s only a 30% probability that buying more stocks when the S&P 500 is back to a record high (during a pandemic) is a good idea. Sure, the index could soar, but I believe there’s a 70% probability that there will be better opportunities over the next six to 12 months. That said, I have no issues with building my cash reserve.
Conversely, I think there’s a 70% probability that buying commercial real estate at depressed prices will turn out to be a profitable move in five years. The market tends to view things in extremes (e.g., the “death of the office”), but things seldomly turn out as bad or as good as pundits think.
Thinking in probabilities allows you to see different scenarios more clearly. And, when an inevitable poor outcome arises, you’ll feel much more at ease.
Sam Dogen worked in investing banking for 13 years before starting Financial Samurai, a personal finance website. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune and The L.A.Times. Sign up for his free weekly newsletter here.