The Four Rules of Long-Held Assets (4Q21 Quarterly Newsletter)

Updated: Nov 4

October 15, 2021

Generally, the older you get the stickier your assets become. The reasons? Over time, people tend to become comfortable with what they own. Under-performing or losing assets are sold off. Less and less money is invested in speculative deals. In effect, the good quality stuff is what remains and people, rightly, tend to hold on to what is familiar and what has worked.

There is also the matter of taxation. As your long-term holds get longer, your unrealized gains tend to increase. This leads to a paradoxical consequence. The more successful the investment the greater the incentive to hold, at least if your low basis asset is owned in a taxable account. Any temptation to sell in a hot market is countered by the realization that the associated tax cost may well exceed any realistically estimated decline in price should there be a market correction.

My own considerable experience suggests four rules when it comes to long-held assets.

1) Just because an asset is selling at or near a high doesn’t mean it may not still have legs. If the conditions that governed its progress to date still apply, then this is a reasonable expectation.

2) The devil you know is better dealt with than the devil you don’t. In practice this means, among other things, there is always a reinvestment risk with sale proceeds. This is less the case should you be moving from a managed securities account (mutual fund, ETF) to another managed account. It emphatically is the case if you have decided that a real estate trade offers you the opportunity to increase your return on equity while deferring tax on the trade. At any given time, only a few readers will actually be interested in a real estate trade so I won’t elaborate here on the advantages and (often downplayed) disadvantages of this subject, but will simply remind you that if and when you are contemplating this possibility give any of the WEIL advisors a call for a review. In this case, the devil really is in the details.

3) A relatively few long-held assets can represent a significant percentage of your net worth. “Concentration,” said economist Maynard Keynes, “is the secret of economic success.” Yes, but as they teach you in Financial Planning 101, “Diversification” (primarily of asset classes) “is the key to successful long-term investment.” Who are you going to believe? As is the case with so many issues in life ... it depends. We all know people, and there are some among our readers, who are very well-to-do and whose businesses constitute material percentages of their net worth. They have learned to live and prosper with asset concentration and are poster children for Keynes. So, by analogy, if you are concentrated in assets that you have lived with long term (and the “innards” of which you understand as well as you know those of your own children) and are confident that in a serious emergency (arising from either exogenous or endogenous sources) you could recover a respectable percentage of their value ... then, fine. If these conditions don’t obtain, and you are uncomfortable with concentration, begin to plan for a slow and steady course of diversification. There are two ways to do this. If your concentrated positions are in marketable securities, you could plan to keep your concentrated positions but embark on an investment plan in which all sources of surplus cash flow are earmarked for assets diversified away from these holdings. This will result, in due course, in those concentrated positions representing less and less of your total assets. In the alternative, you could set a target date (perhaps as far out as two or three years) by which time you plan to have your concentrated positions reduced to a less “impressive” size, and then begin, say monthly, to sell down toward that chosen size. The longer-term selling runway will mitigate the tax burden (although note that current proposals to increase capital gains rates could tank any mitigation). There are also option strategies that can, to some extent, soften the costs associated with diversifying. Incidentally, if your concentration is in real estate holdings there may be a compelling argument for a tax-free exchange (or, more accurately, a series of tax-free exchanges in which your one big holding exchanges into a number of smaller holdings). It is complex but, with proper advance planning, it can be done.

4) The trend line is your friend, assuming it’s going in the right direction – and you wouldn’t be owning assets, at least not for long, where the trend line is going in the wrong direction (unless, that is, you’re a member of the school of thought that believes you can’t sell until your selling price equals or exceeds the price you paid). Ignore volatility. When your assets are “overpriced” the market reflects (often) undue optimism. When your assets are “underpriced” the market reflects (often) undue pessimism. For a good quality asset, the long-term price trend line should reflect the performance of the asset in accordance with reasonably well understood metrics, through good economic times and bad. Daily, weekly, monthly, even yearly price ranges, whether for individual assets or aggregated into indices and averages, tend to reflect the (euphoric, despondent, confused) passions of the shorter-term moments.

And speaking of long-term investment holds, you may be surprised at the extent to which long-term- investment-hold strategies contribute to income inequality (or more properly, to wealth inequality given that income is a function of the capital (current or expected) available to produce it).

Let me set the stage with two examples that illustrate this. You own an income property bought in the mid ’90’s:

* Yes, I know that you were unlikely to get a 25-year amortizing loan without a 10-year call, but you can achieve the same result by refinancing the then loan balance at the end of years 10 and 20, each for a new 25-year amortization term. Assuming no change in interest rates or debt service, your loan would be fully amortized in 25 years. In the real world, your rates would have gone down in years 10 and 20.

Note the price paid was based on a 6% capitalization rate. Another way of saying this is that the buyer was willing to pay a price ($500,000) on which the net operating income before debt service and depreciation resulted in a 6% ($30,000) cash flow (not taxable income, because items such as depreciation and amortization of capital expenditures have not been included).

Depending on such things as property location and condition, this looks like a pretty good deal. Annual cash flow (net operating income less debt service) of $3,000 (or 2% on equity) is not bad considering the 70% financing. Cash flow would almost certainly be negative in today’s world.

Fast forward to today. The loan is paid off:

  • At 3% per year average increase in rents, current rental income is $125,600.

  • At 3% per ye