Selling all or part of a profitable investment is a tough choice to make. On one hand, holding the investment allows time to accumulate a high return, but at the risk of losing profit in the market’s next big decline. On the other hand, selling portions of the investment to ensure a profit today will diminish the future return.
Both choices are easy to illustrate by imagining a stock investment that pays no dividends. Assume there is a consistent growth of stock price and that no additional shares are purchased after the original purchase. The profit is skimmed by selling part of the investment when its market value grows to twice the original purchase. Repeat the process every time the market value doubles until the investment is closed. Chart 1 illustrates the skimming of a $1,000 investment.
After 5 years, the investor could claim a profit of $1,000 on the original $1,000 investment. Then the choices would be to close the investment at $2,000, withdraw only the $1,000 profit and wait for more (green circles), or withdraw nothing and wait for a bigger profit (black squares). The largest profit is made by waiting 20 years.
Chart 2 illustrates the accumulated cash balances of the HOLD and SELL strategies.
After closing the investment in 20 years, the accumulated cash balance would be $16,367 from the HOLD strategy and $5,045 from the SELL strategy.
The accumulated cash balance will vary according to the annual rate of return (appended chart 3), the amount skimmed (appended chart 4), and the payment of dividends (appended chart 5). In every condition, the total profit of the HOLD strategy exceeds the total profit of the SELL strategy.
On the question of whether or not to skim profits, skim if you need cash in the next 5-10 years. Otherwise, don’t sell without reassessing the investment or using a risk management scheme. The question of selling for a loss was excluded from this discussion; that’s a different topic.
Appendix: Tables of cash balances
Charts 3-5 are tables of cash balances that represent profits from an imaginary investment of $1,000. The choices for taking a profit were to HOLD the investment for 20 years before liquidating the account or to SELL profitable portions of the investment. Assume there were no trading fees.
Chart 3 shows that a 15% annual rate of return earned a bigger profit than a 7% annual rate of return. Furthermore, the HOLD strategy earned a larger profit than the SELL strategy at both rates of return.
Chart 4 illustrates the effect of skimming 50%, 100%, or 150% increments of market value.
The HOLD strategy outperformed the SELL strategy. With the SELL strategy, waiting longer to skim bigger profits accumulated a larger cash balance after 20 years. Why? The bigger profits were less frequent, which had the effect of preserving the investment’s principal for longer time periods.
Chart 5 reveals a surprising effect for skimming profits from reinvested dividends.
There were no surprises in the HOLD strategy. Reinvested dividends accumulated the largest cash balance over 20 years. However, reinvested dividends accumulated the lowest cash balances in the SELL strategy. Why? Slightly more shares were sold every 5 years from ‘reinvested dividends’ compared to ‘no dividends’. Yet the same number of shares were sold from ‘cash dividends’ compared to ‘no dividends’. The cash dividends directly augmented the cash balances.
Copyright © 2017 Douglas R. Knight