Let Your Profits Run: Embrace Simplicity

“Let your profits run, and cut your losses”. Is a phrase coined by economist David Ricardo encouraging investors to resist the urge to sell profitable positions too early. The adage has roots in simple math. A losing position can only fall 100%, whereas a winning one can potentially gain infinitely. So, how can this timeless wisdom help investors today? This post will explain the basic logic of Ricardo’s timeless advice. And, go on to show why investors who subscribe to fashionable re-balancing strategies promoted by typical wealth management firms ensure poor performance and potentially imperil their financial goals.

Choose A Portfolio

As we begin, consider a simple choice:

Would you rather own a portfolio worth $200,000 that is diversified so that no single holding represents more than 10% of the total? Or, a portfolio worth $400,000 where a single holding represents 50% of the total?

At its face, most investors will choose the portfolio with a higher total value, no matter what the composition is. But in practice, most investors inadvertently choose the portfolio with a lower value.

Why? Because instead of letting the best investments run their course. Most investors choose to “take profits” by selling them instead. The result is a portfolio with results that can’t match the benchmark index and returns that are less than their potential.

Emotional Fortitude Matters

The reasons why we choose the underperforming portfolio in real life has to do with two main factors. Our psychology, and so-called “expert” advice that re-enforces our bad decisions.

First, we fear loss more than we take joy from gains. This loss aversion bias makes us fearful when we should be calm. We sell our best investments after early gains instead of letting our profits run. Cutting off our returns at the knees.

Second, most investment advisors justify their fees by tapping into our emotions. They promote their supposed ability to manage risk. And, one of the ways advisors do this is by re-balancing. In other words, they ensure a portfolio always tends towards its initial target weights.

Let Your Profits Run

To help illustrate how selling your best investments and re-balancing to an initial target asset allocation will hurt your returns, let’s deconstruct our portfolio choice even further.

To re-cap, two portfolios exist. The first portfolio has a value of $200,000 and is diversified in a way that no single holding makes up more than 10% of the entire portfolio value. The second portfolio has a value of $400,000 but a single holding makes up 50% of the entire portfolio value.

What if I told you that each of these portfolios started with the same value at the same time with the exact same holdings. The only difference is the portfolio with a lower value sold its best investment after it doubled. While the higher value portfolio “let its profits run” without selling.

Each of these hypothetical portfolios started 10 years ago with initial investments of $2,000 into the same 50 stocks. 50 stocks for $2,000 each means each portfolio started with $100,000 of initial value. Over the course of 10 years, as we should expect, some of the stocks performed well while others were bad. A few of the companies went bankrupt. But, one of the 50 stocks rose by 100 times its initial value.

Keep in mind that each of the two hypothetical portfolios started with the same amount invested in the exact same 50 stocks.

The only difference is the portfolio worth $200,000 sold its best stock after it had doubled in value. While the $400,000 portfolio simply kept the portfolio composition the same over the course of the portfolio’s 10-year lifespan without making a single sale.

The higher value portfolio captured the full value from the gains in the stock that rose by 100x. While the lower value portfolio sold early.

Cold, Hard, Facts

The result of the first portfolio is that it doubled in value over the course of 10 years. Rising from $100,000 to $200,000. Sounds pretty good right? Most investors might initially be happy with these results. If your investment advisor doubled the value of your portfolio you might think this was pretty good too.

By contrast, the higher value portfolio let its profits run. A single holding within that portfolio rose from an initial value of $2,000 to become worth $200,000. In other words, a single holding became 50% of the entire $400,000 portfolio value.

Does “Let Your Profits Run” Actually Work?

Is this a realistic scenario? Yes. As Efficient Market Theory suggests; if investors make enough investments, its highly likely they will choose a great one eventually. Even if those investments are chosen randomly. Eventually, its likely investors will choose a stock like Microsoft, Apple, NVIDIA, Constellation Software, Amazon, or Monster Energy.

Outside of the stock market, some real estate investments can go up 100x given the right circumstances and enough time (and some leverage). The same is true with other alternative investments including private equity.

The key difference between hitting a homerun investment and not; isn’t whether you can find a great investment to make. As this post has described, hitting a homerun investment has more to do with letting it happen. This means your emotional approach. Can you hold on?

More Examples from Real Life

What’s one of the main reasons why great investors like Warren Buffett achieve such great results? Or, why do index funds consistently outperform professional fund managers? Its not because of their exclusive access to special investments. Its mostly due to the fact they let their profits run (and they keep their costs and taxes low).

Warren Buffett is famous for never selling his great investments. He’s held the same portfolio of investments for most of his investing life. Never selling.

Beating the Benchmark

Likewise, the S&P 500 is tough to beat because the index is designed to buy-and-hold. The S&P 500 doesn’t rebalance, but rather, simply holds a market weighted portfolio of the 500 largest US companies. The only times when investments are sold by the S&P 500 is when they drop out of size (they are too small, partly because they perform so poorly) and when a company is bought out. Otherwise, the S&P 500 is simply a buy-and-hold portfolio.

It’s the Coffee Can portfolio. And, the simplicity of this approach is what makes it so powerful.

Our Experience

Our family office has experienced lots of homeruns. And, during my time as an investment advisor before managing our family office, I’ve witnessed lots of investors hit homeruns of 100x (and more). I’ve personally made several investments that have gone up 10 times and even some “100 baggers” a few times. And, my good fortune is not due to luck or skill but simply because I’ve made enough (reasonable) investments over the years, eventually, some have hit big.

The challenge is holding the great investments you’ve made even as everyone around you is yelling “sell!” Because, the only way you’ll ever get to 100x is to pass 2x, 5x, 10x, and 50x. You must be willing to hold on even after big gains.

The Results Might Make You Nervous

Lastly, how does the pareto principal factor into all of this? Well, it turns out that when a portfolio outperforms, it will naturally become concentrated. Since, the great investments that pull up the return will also end up making up a large part of the total portfolio. Go back to our example of the $400,000 portfolio where 50% of the total is held in a single stock.

So, as an investor who hopes to achieve high returns, you’ll need to be comfortable with concentration. And, the risk that concentration brings.

Embrace Simplicity: Let Your Profits Run

Many wealthy investors, who have either become rich by inheritance or by selling their business think that investing success depends on technical skills. But, deciding which stocks to trade, which real estate investments to make, or whether they should include private equity or infrastructure in their portfolio matters a lot less than simply buying a portfolio of high-quality investments and holding them for the long-run.

If your goal is finding financial peace of mind; or even if it includes making a social or environmental impact on the world. Your financial goals will not be achieved by stock picking. However, the path towards financial peace of mind can be achieved by embracing an easy to understand investing philosophy. One that you can pass on to future generations.

This is the approach to investing that our family office supports. And, to learn more about how we help investors, click here to get in touch with us.

Let Your Profits Run

The essence of letting your profits run lies not just in resisting the urge to sell profitable investments too early, but also in understanding and embracing the psychological and strategic aspects that come with long-term investing. The distinction between achieving mediocre returns and realizing significant wealth over time can often be attributed to the courage to maintain one’s investment convictions amid market fluctuations and the noise of rebalancing rhetoric.