In the United States, the sale of an appreciated stock holding will trigger capital gains taxes. In addition, 41 states tax capital gains, on top of the federal tax. As of this writing, the effective top federal capital gains tax rate is 23.8%. State income tax rates go as high as 13.3% in California, with San Francisco adding another 0.38% to bring the rate up to almost 13.7%. But the highest rate in the nation is found in New York City, where the combination of state and city income tax exceeds 14.7%.

Thus, people who live in New York, California or other high tax states can face capital gains taxes approaching 40%. The average state income tax rate is about 6%, meaning that the average top capital gains rate in the US is 30%.

The desire to not pay 20%, 30% or more of your gain is a powerful reason for people to hold onto concentrated positions, even though they know they lack control, and even though they know they incur excess risk by holding the concentrated position.

Breakeven Takes “Forever”

Suppose you are in the fortunate position to have a large gain in a concentrated position. For the sake of discussion, suppose that the overall value of your portfolio is $10 million, and you have a single position that is worth $2 million.

Using portfolio theory, and some basic assumptions about the volatilities of the average stock, we can calculate that the concentrated position is adding about 1.5% per year of risk (standard deviation) to the portfolio. Or, looking at it the other way, diversifying the concentrated position would reduce the risk of the portfolio by about 1.5% per year.

That might not sound like much, but the way the math of compound returns works, everything else equal, higher volatility of a portfolio equals lower returns.

However, that math is more than we want to go into here (and probably more than you want to read about). For the sake of this discussion, we’ll just say that the reduced risk corresponds to an increase in expected return of about .06% per year.

However, the portfolio will shrink, because of the capital gains tax. As Shakespeare said, “Aye, there’s the rub.”

Assume you paid $100,000 for the stock that is now worth $2 million. At the average tax rate of 30%, the tax on the capital gain from selling the $2 million position would be about $570,000. Thus, the value of the total portfolio after such a sale, and after taxes, would be $9,430,000. The lower risk portfolio will have a slightly higher return. But it would take over one hundred years for the higher return to make up for the tax hit.

Prospect Theory

Nevertheless, people are often willing to pay the tax to reduce the risk. The bigger the concentrated position, the greater the willingness, because the bigger the position, the bigger the downside.

If you have $40 million, and it’s mostly in one company, and that company hits the skids, your life will change a great deal for the worse.

For most people, a large loss hurts more than a gain of the same amount feels good. For example, if you have a net worth of $10 million, it is likely that you would feel more pain from a $2 million loss than you would feel pleasure from a $2 million gain.

Most people feel this way, and the psychologists Amos Tversky and Daniel Kahneman became famous partly for documenting this fact in a number of experiments.

But you don’t care how other people feel. You care about how you feel. And if you’d feel more pain from a large loss than you would pleasure from an equal size gain, that’s a strong reason to think about reducing a concentrated position.

Status Quo Bias

Almost everyone can recall a situation in which they failed to take advantage of some obvious opportunity, even when the cost of acting was low, the risk was low or zero, and the potential for gain big. All of us, it seems, are sometimes afflicted by the desire to just sit there.

You can probably recall at least one such situation.

If so, you’re not alone. In fact, researchers even have a name for it. They call it the status quo bias. Most people have a tendency to prefer what they have, whatever that is, over alternatives, simply because they already have whatever it is. For example, in one study, researchers found that test subjects valued a coffee mug much more highly when they already had the mug compared to when they didn’t already have the mug.

A variety of carefully conducted studies[1] have found that even highly intelligent people, who are very successful, frequently make this kind of decision. The researchers call such behavior irrational. Here’s a quick example of why. You’ll see that when it’s explained, people usually abandon their irrational behavior in favor of more rational behavior.

Consider a study done at Simon Fraser University. Researchers kept everything else the same, except that they gave one set of subjects a mug, asked another set how much they’d be willing to pay for a mug, and a third set got the choice between a mug and cash. The subjects who were given the mug (on average) wouldn’t sell the mug for less than $7.12, while the other two groups valued the mug much lower, at $3.12 and $2.87.

Investors also can be subject to status quo bias. For example, you might be unwilling to buy a stock that has already gone up a lot, but if you already own it, you might continue to own it.

If you are willing to own a stock that has gone up a lot, but you wouldn’t buy the stock at that price, that could be a case of status quo bias.

The good news is that you, when you are aware of status quo bias, can overcome it more easily.

To understand how you might be able to overcome status quo bias, click here to apply for a pre-publication copy of our latest book, The Intelligent Layman’s Guide to Personal Investing. Or call 703 437 9720 and ask for Connor or Katherine.