Why Selling Your Equity at a Low Still Makes Sense

By John Owens CFP®, EA, ECA, CPWA®

The last few months have brought some major market volatility - especially to the growth stock space. With many recently IPO’d companies well off their all-time highs - and even their prices a few months back, we’re often asked if it still makes sense to stick to trading plans - and sell at a ‘low’. The answer is often yes, but we should probably talk about why.

At issue here is the fundamental concept of ‘opportunity cost’ and ‘risk-adjusted returns’ - two fairly nerdy concepts we must consider all time. Opportunity cost is defined as the “the loss of potential gain from other alternatives when one alternative is chosen”. What’s that mean, exactly? When we think about in the context of investing, it means picking one investment over another and what that ultimately means for your bottom line. Or, to put it in more relatable terms - it’s FOMO (fear of missing out). 

Risk-adjusted returns, on the other hand, are a means of comparing the returns of two different investments that accounts for the inherent differences in their underlying risk - for example, your company’s stock vs.  a broader stock market index. Better put, it’s how dangerous (or, perhaps a better phrased as risky) that event you’re missing out on is. 

Failure to consider opportunity cost and risk-adjusted returns can lead us to follies in trading our equity and have grim results. Let’s talk about what they mean and walk through an example. 

Opportunity Cost

Let’s take a look at company - we’ll take Spotify for example, to better understand how opportunity cost works. Assume we have some stock in Spotify - $100,000, that we acquired a couple years ago when we exercised some stock options. The stock was once worth almost $200,000 - as recently as last spring, but recent volatility has caused a drastic sell-off. Thankfully this stock was acquired at a very low strike price from options granted several years ago, so the investment is still at a profit. 

Now, when evaluating what we can do with these shares of SPOT, we need to consider a variety of factors - including what we think will happen with the company stock going forward. But our analysis cannot stop there. - that’s only the beginning. 

We must also consider what we can do with the funds if we were to sell them with an infinite number of alternatives in which they can be invested. So the question is not how well SPOT do over the next few months, years, or decades, but if you had $100,000 to invest anywhere in the world - would SPOT be the best place to put it? And when thinking about that decision, we need to think about risk-adjusted returns. 

Risk Adjusted Returns

Bear with me a second as we’re going to get a little technical! One of the ways we compute Risk Adjusted Return is known as the Sharpe Ratio. The Sharpe Ratio compares the return of a security (like stocks or ETFs) with risk-free securities (treasury bonds) acknowledging the variability in returns. What’s that mean exactly? It means we can compare two investments’ returns in a way that levelizes their risk - i.e. am I getting enough return to compensate for the fact that this investment is inherently risky. 

I’ll spare you the details but we ran analysis of Spotify over the last few years and compared it to the broader Vanguard Total Stock Market Index (VTI). In doing so, we found that the Sharpe Ratio of Spotify is 0.29, while that of VTI is 0.93. This basically means that for each unit of “risk” we’re taking, we’re getting 0.29 units of return with Spotify. With the index, we’re getting 0.93 units of return for each unit of risk. So, in this case, the same amount of risk gets us much more return with VTI than it does with Spotify. In investing, that’s great - a higher return for a similar level of risk. 

So, why does this mean that I should I sell low?
With many company’s stocks off their all-time highs after a volatile time, we need to consider if we remain invested in those securities, what are we missing out on the in broader investment world. Our bias towards anchoring to higher, prior prices and the hopes of a rebound can lead to poor decision making. Instead, we need to consider what the risk adjusted returns of the investment options. If there’s an investment that can potentially provide a better risk-adjusted return over the long-term, it can be incredibly efficient to sell off some equity sooner rather than later, regardless of the price. 

Additionally, a sell-off can also help reduce the tax hit that comes from stock sales. By selling at a low, you can get diversified more quickly with less of a tax bit - alleviating some of the hurdle that can make selling off stock less palpable.

Despite the rocky waters of the past few months, a sell off does not inherently mean we should stop selling our risky, concentrated stocks. On the contrary, we can use this opportunity to boost our risk-adjusted returns and decrease the opportunity cost that comes from holding concentrated equity - two factors that can turbo charge your financial plan over the long-term. Fundamentally, it’s important to have a trading plan for your equity compensation and to take an unemotional approach to unwinding it regardless of the day-to-day volatility in the stock market.