Retire the Jersey of Your Aging Stocks

Physician's Money Digest, September30 2004, Volume 11, Issue 18

When baseball executives talk about lettingan older player go whose skillsmight be deteriorating, they commonlyoperate on the belief that it's better tolet the player go one season too soon rather than aseason or two too late. They might not benefit fromthe player's last productive season, but the contractmoney saved in having to play a nonproductive playerpast his prime will offset that loss.

It's no different with stocks, where one stock mayhave helped you earn a lot of money over the years.And just like that baseball player, it's difficult to cutloose an old friend that has been so reliable. But, doyou really want to take the chance on losing a significant portion of the wealth you've accumulated?

End of the Season

BusinessWeek

An article in indicates that nowmight be the best time in decades to sell that winningstock and diversify. One important reason is that thetop federal long-term capital gains tax rate, whichapplies to sales of stock held for more than 1 year, isonly 15%, down from 28% a decade ago. Accordingto Daniel Loewy, research director at BernsteinWealth Management Research, the average large capstock is 44% more volatile today than a decade ago.

The article explains that selling that large, winningstock now and reinvesting the proceeds in adiversified portfolio can provide you with enhancedreturns with less risk, on average. Consider that theS&P 500 has earned a higher average return (13%)than the average single stock in the index (10.3%)since 1984. That's because not all stocks in the indexrise and fall together.

How much should you sell? Loewy suggests asmuch as necessary to protect your goals, like guaranteeinga certain standard of living when you retire.Also, consider your time horizon. The longer you canafford to invest the proceeds from a stock sale in adiversified portfolio without touching it, the more ofyour stake it makes sense to sell. Your financial advisorcan help you with these calculations.

Lineup Change

If you're unable to sell that stock at the moment,there are some options to consider. One is called a collar.According to the article, this involves purchasinga "put," which is an option that allows you to sellyour shares for a specific price. Suppose your stocktrades at $100 per share. You could purchase a put forabout $3, which would guarantee a $90 sale priceover time periods ranging from 1 month to 3 years,thus limiting potential losses.

If you have stock worth $3 million or more, anotherconsideration is a contract called a prepaid variableforward (PVF). According to the article, if you owneda stock worth $100, an investment bank pays you afraction of the stock's current value, such as 85%. Youcan then invest that $85 a share in a diversified portfolio.If the stock price falls, the PVF protects you andyou keep the $85. However, you'll have to pay taxes onthat amount, leaving you with about $72 at the 15%capital gains tax rate. But if the stock rises, you stillreceive the $85, plus a share of the gains.

Extra Innings

When the PVF expires, generally in 2 to 5 years,you can turn your stock in to the bank, which willtrigger a sale and a tax bill, or delay paying taxes bydelivering the cash equivalent to the bank and keepingthe stock. What you'll owe will depend on the stock'sprice when the contract expires.It's never easy to part with a winner. But protectingthe wealth you've accumulated through a diversified portfolio is more important to your financialfuture than loyalty to one stock.