A Love Letter to Unrealized Gains… and Their Owners

Dear Unrealized Gains,

Let me start by saying – as an investment you have been great.  It has been a great run and I hope to remember all the good times (i.e. market run-up) we have shared.  But… it might be time for us to sell and realize you, unrealized gain.

Every advisor has heard it from a client (often delivered in whispered confession, as if in a cathedral of financial shame):  “I know I should trim my position (or sell outright)… but the taxes would be brutal.”  THIS is the great psychological barrier of unrealized gains.  Should we sell and pay the taxes on the gain or keep the investment and hope it continues to appreciate?  I would suggest that taxes should not drive this investment decision. 

Don’t get me wrong— taxes matter.  They should be considered, calculated, estimated, and maybe even openly discussed (although probably not at cocktail parties.)  But they should not be the primary determinant in deciding whether to continue holding an investment that has run beyond its reasonable allocation, valuation, or risk contribution.  Let me offer some thoughts on why.

The Behavioral Trap

Investments that have appreciated significantly feel like old friends — profitable old friends.  Considering selling a highly appreciated investment can trigger a feeling of loss aversion (despite the gain, the tax feels like a loss) or even a status quo bias (let’s not do anything, after all, this investment has done so well).  Taxes amplify emotion and emotion (typically) makes for bad portfolio decisions.

Opportunity Cost > Tax Cost

Consider a simple example.

• Stock A was purchased for $50,000 and is now worth $150,000

• Long-term capital gains maximum federal tax rate is 20% plus 4.25% if NC resident and plus another 3.8% for the net investment tax in some cases.  To standardize for illustrative purposes I am going with a net tax rate of 25%.

   

If sold, net after tax value (tax is on the gain only) is $125,000.  The calculation is:  $100,000 gain times 25% = $25,000 of tax.  But, you sold and got $150,000 in cash so the final tally is $125,000 after paying taxes.

OR, that same investor hangs on to the investment to “avoid” $25,000 in taxes… and now that investment corrects (falls) by 25%?  The new value is now $112,500 (150,000 *75%).  So, as a result, you “saved” $25,000 in taxes – today – but “lost” $37,500 in market value.  Congratulations — you are now tax-efficient and portfolio-inefficient.  And, you still have future capital gain to pay when you sell!

Portfolio Construction Still Matters

When an investment appreciates significantly, its weight in your portfolio doesn’t just get larger — its influencedoes.  That influence shows up in places investors rarely check:

• Relative risk contribution

• Possible sector or factor (growth, quality, momentum, etc.) concentration

• Correlation clustering (e.g. market movement can be amplified)

• Drawdown sensitivity in market stress events

A position that grows from, say, 3% of the overall portfolio to 10% is no longer a quiet passenger on the bus — it’s now grabbing the steering wheel and “suggesting” directions.  It is critical to keep in mind that portfolio construction is less about picking winners and more about controlling unintended consequences.  A highly-appreciated stock may be wonderful on a one-line performance report, but that’s not how real risk works.  Just because something grew into a large position doesn’t mean it deserves to be one in your portfolio.  If you wouldn’t allocate 10% to that position today (fresh cash, clean slate), then you are not investing — you’re time-travelling with baggage.  And while the IRS might send you a bill for trimming or selling that investment, the market charges interest for ignoring risk.

Metrics That Should Outweigh Tax Impact

My last suggestion for thoughts on realizing unrealized gains is to evaluate how that holding impacts your portfolio:

• Standard Deviation Contribution – Which position contributes most to variability?  If your “winner” spikes volatility significantly that deserves attention.

• Beta / Correlation Drift – Positions that once diversified now often move in lockstep with the market (looking at you, mega-cap tech).

• Forward P/E vs. Historical P/E – If the valuation has expanded much faster than earnings, congratulations, you own multiple expansion, not growth.  While that can last for a while just be aware that multiple expansion likes to end abruptly.

• Rebalancing Tolerance – If you rebalance a portfolio only when the asset allocation changes substantially, ignoring the shift in asset allocation that comes from a substantial gain in an investment is not a tax strategy — it’s a risk strategy (and it’s passive).

   

Keep in mind that disciplined rebalancing historically:  improves risk-adjusted returns, reduces drawdown severity, and helps to sustain diversification benefits.  And, just as a reminder – the S&P 500 has seen 14drawdowns of 20%+ since 1950 (1).  Gains can (and do) vanish faster than your New Year’s gym commitment and, unlike in recent years, it can take a while to get those gains back.

When Taxes Can Justify Holding an Investment

To be fair, there are legitimate reasons to defer taxes:

• You are within weeks of a long-term threshold

• Your tax bracket will be meaningfully lower next year (e.g., retirement)

• You plan to donate appreciated shares (you know I love a Donor Advised Fund… for example)

• You intend to gift shares to lower-bracket family members

• Step-up in basis may be relevant for estate planning

These are strategic — not emotional — decisions.

When Taxes Must Be Secondary (or Tertiary)

Consider selling, trimming, or collaring if:

• The position’s volatility contribution exceeds its return contribution

• The allocation is now out of range of stated goals and risk tolerance

• Valuation metrics disconnect from fundamentals

• You’d never buy the same position at current weight today

  • If you wouldn’t purchase it now… you’re essentially holding because you don’t want to pay a bill.

     

Closing Thought(s)

Taxes are an important consideration in financial planning and investing.  In fact, taxes should be considered, modelled, and minimized (within reason)… but not feared.  When taxes become the primary reason to hold, you’re no longer optimizing returns.  I would argue you are most likely optimizing for regret avoidance.  Paying capital gains is part of investing.  Paying the tax is not a penalty — it’s a feature.  The markets reward discipline, not procrastination, not “hold and hope” — and definitely not tax-driven hoarding.  Portfolios change, rebalancing should be intentional, and risk should be managed.  So, (as this is a letter to unrealized gains)…

Unrealized gains, it has been great and I hope we can remain friends (and I can see you often in the future) but let’s “take a break” for now as I have my eye on some new investments that I think may be a better match for my portfolio.  No hard feelings!

Best wishes,

Long-term Investor