A Tale of Respect





Have you ever heard someone say, “After all, what can happen?”  It’s never really a question.  It’s more of an assertion.  It starts with the phrase, “I’m going to” or, “We’re going to…” and ends with the phrase, “After all, what can happen.”  Are you kidding me?  Anything can happen.  In this tale, the exact comment was, “I’m going to hold my MCI stock until next year to lower my tax bill.  After all, what can happen?”  This tale will teach you that a lot can happen in a year.  You must respect the future because it’s unpredictable.  One of my favorite sayings is the following—There are two types of unknowns, the unknowns you know about and the ones you don’t.  This is a case of an unknown, unknown.  We also witness once again the violation of the cardinal rule of “once wealthy, stay wealthy.”  Here’s what happened.

John had worked at MCI for the last 15 years and he was in his early forties.  John was not exactly what you would call a high achiever.  Work does not come first in his life.  He’s a wonderful human being and the type of fellow that went to work every day, enjoyed what he did and took pride in his work.  John’s company, like so many in the telecommunications area, had the practice of issuing options to employees and John had accumulated quite a few.  John is a friend, and when he asked in early 2000 what he should do with his options, I told him to cash in.  He should exercise them, then sell the stock and pay taxes on the gain.  Of course he didn’t.  Friends never take other friends seriously.

Here was a guy that if he did as advised would have paid well over a $1 million in taxes but would be worth almost $3 million when it was all over.  To John, this represented more money than he had ever dreamed of making.  What did John do?

He exercised his options under his company’s plan, but he did not sell the shares he exercised.  He made a conscientious decision not to sell the shares because he could potentially cut his tax bill in half.  In other words, John made an investment decision predicated 100% on reducing his taxes.  This is always a mistake.  The most successful people I know evaluate the tax ramifications of their actions.  Taxes are one of the variables they consider.  However, they seek to maximize their after-tax rate of return, and if that means paying more taxes, then so be it.

John took a chance.  He made a calculated decision.  He even went to his accountant to determine the exact tax ramifications of his actions.  He knew all the possibilities and understood them.  However, Bill miscalculated the volatility of stocks.  He particularly miscalculated the volatility of his particular stock.  He was willing to roll the dice.  He could potentially cut his tax bill in half, if the price of his company stock cooperated.  The risk he took was as follows.  He could sell his shares immediately and pay taxes on the profits.  He could wait to sell them a year later, and if the price of the stock was at the same price as today, he could cut his taxes in half.  What he didn’t factor into the equation is what would happen if the price of the stock went down precipitously.  If it went up, stayed about the same or went down a little he would certainly be better off.  However, if it went down dramatically, he was in big trouble.  He would still owe taxes and if he wanted to pay the taxes by selling his shares, they would be worth significantly less.  Ask yourself whether this is a risk worth taking.  After all, what can happen?

This tax savings seemed substantial enough that John felt the risk was worth taking.  After all John reasoned, the price of his MCI stock would have to drop precipitously in order for him to come out on the short end of the tax stick.  As we all might have guessed, Bill bet wrong.  His company stock declined substantially, and the following April when Bill was due to pay his taxes, he was broke and needed a small loan to pay his taxes in full.  The sure $3 million was gone for the potential of a few dollars more.  After all, what can happen?  Disaster can happen!  You must give the market the respect it is due.  If it can go wrong, it might just happen.  John should have followed the wisdom of the ages—“a bird in the hand is worth two in the bush.”  He should have paid the additional tax.  Another expression that applies to John is “penny-wise but pound-foolish.”  I say, when wealthy, stay wealthy.  In addition, don’t ever make a decision predicated exclusively on taxes.  They are just one of the variables to consider.

Let’s look at another, “What can happen?” situation.  This is the case of Mark and Doris, and it transpired in 2001.  They were building their retirement home somewhere in the Carolinas.  The plan was to sell their present home after their retirement home was finished and then relocate.  Mark was in charge of the investments for their family and had been successfully trading stocks for many years, or so he said.  However, he, like so many others, was lulled into a false sense of confidence by his success.  He lost perspective and thought that past success, during an extended bull market, would continue forever.  He was wrong.  His is just another case of a person who mistook trading acumen for a bull market.  What happened to Mark and Doris?

Mark and Doris had lost more than half the value of their portfolio by the time they came to see me.  The reason for the sharp decline in their portfolio value was due not to the nature of the investments that Mark had selected, but to the overall risk level of the portfolio.  He had 100% of their portfolio invested in the stock market.  This is an acceptable strategy for someone that is building wealth or someone that has more wealth than they could possibly spend assuming proper diversification, but not one that I would recommend for someone in their situation.  He was way off in his thinking.  They were wealthy, they had specific plans and had they focused on their plans, they would have known that they could accomplish them with less risk.

Unfortunately, past success, meaning the past bull market, had taught Mark that stocks always go up.  We all know they don’t, and by the time I met with them, they knew it as well.  Fortunately, their portfolio was still large enough that they could carry off their plan to relocate.  It meant giving up some of the things they might have wanted, but it wasn’t a drastic change.  Mark had learned to respect the markets by the time they moved to the Carolinas.

This brings me to another golfing-is-like-investing lesson.  A well-designed golf course typically has a number of shots where the golfer must decide if they want to take a risk for the potential reward.  One such risk is whether you want to try and hit a shot you might execute six or seven times out of 10 and fail at three to four times out of 10.  Golfers weigh the pros and cons and then decide, often based on their confidence level at that particular moment or their current state of mind.  If they choose to take the risk, they need to go for it with full confidence.  They need to be fearless.  However, if they choose to play it safe, they must also play safely with full confidence.  By playing safe, I mean they have to allow a margin of error.  For instance, if “playing it safe” means a player has to hit the golf ball short of a pond to avoid a penalty, should they try to hit it a yard short of the pond or twenty yards?  The answer is twenty yards.  Very few golfers are talented enough to distinguish between a shot that goes into the pond and one that stops a yard short.  This means when playing it safe, play it safe.  How does this directly translate to my investment thinking?  The answer is I don’t reach for yield.  If I want money to be safe in the short term, I keep it safe.  If I want to take a risk, I take a risk.

The word safe is a relative word.  One of my sayings is, “One man’s safe is another man’s danger.”  Let’s look at one last example of, “What can happen?”  People love to reach for yield.  Let me translate.  It means they try to get something for nothing.  Typically, they do it with low volatility products such as money market funds, CDs or short-term bond funds.  They see where a particular fund might be paying 2.45% while another is only paying 2.40%.  They reach for yield and invest in the higher paying one.  Over the course of a year, a $100,000 investment pays an extra 0.05%, or $50.  Before you know it, the higher yielding fund runs into trouble, and the investors find out it wasn’t as “safe” as they thought.  So, when you reach for yield, don’t do it for a measly $50.  It isn’t worth it.  If you want to make more, look at investment opportunities that can make you substantially more.  Take the risk for the commensurate reward, but don’t do it for peanuts.  Don’t reach for yield, because you are not giving the markets the respect they deserve.    

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