Harvesting returns from your “explore” investments

One way to manage a core-and-explore approach and keep reasonable checks on your behaviour is to limit the “explore” part of your portfolio to no more than 5% to 10%. The amount is up to you, but the point is to decide ahead of time what your explore threshold will be and what rules you’re going to follow—and then stick to those guidelines over time.

Staying disciplined with this portion of your investment portfolio is important because speculative investments such as individual stocks, thematic ETFs and cryptocurrencies can be incredibly volatile. That means your 10% “play money” allocation could quickly become 20% of your portfolio (or more) if one of your speculative picks pans out. Conversely (and perhaps more likely), one of them might turn out to be a dud and lose 50% or more in value.

Just as you would rebalance your core portfolio of diversified ETFs to maintain your original asset mix between foreign and domestic stocks and bonds, you should also rebalance your explore investments when they exceed the threshold you set.

Why take profits?

It sounds counterintuitive to sell a profitable investment and harvest some of the gains, but that’s exactly what you should consider doing if you want your portfolio to remain in balance and maintain a sensible risk profile.

Let’s say five years ago you bought 500 shares of Tesla stock (NASDAQ: TSLA) at a price of $39.33 per share (all figures in U.S. dollars). Your holdings would have been worth just under $20,000. Fast-forward to today, when Tesla shares trade at $996.27 (as of Jan. 21, 2022). Your shares are now worth a whopping $498,135, assuming you’ve held the stock for the entire five-year period.

It’s safe to say your shares in Tesla now represent a far greater percentage of your overall investment portfolio than they did five years ago.

Why sell a stock that’s on such a profitable trajectory? Because its future returns are unknowable. Tesla could continue to lead the electric vehicle and clean energy revolution, or it could fizzle out as other companies emerge on the scene.

Individual stocks can also be highly volatile compared to the broad market. Take the period between February and March 2020. Tesla shares were down 52.55% during that time. Between January and May 2021, the company’s stock price was down 34%.

Yes, it’s true that a global balanced portfolio will not deliver total returns of 2,800% over five years like Tesla did. Those are the kind of lottery-like returns investors strive for when they adopt a core-and-explore approach.  

Your core portfolio, meanwhile, is supposed to be the risk-appropriate and steady vehicle that makes up the bulk of your retirement savings. It’s not prone to the wild swings that individual stocks, thematic ETFs or cryptocurrencies bring to the table.

Case in point: The Horizons Balanced TRI ETF (HBAL) represents a balanced portfolio of 70% stocks and 30% bonds from around the world. During that same period in 2020 when Tesla’s share price was down 52.55%, HBAL’s price was down only 20.83%.

A reasonable approach to take with your Tesla shares would have been to sell half of your gains each time the stock price doubled and put the profits back into your core portfolio. This way, you’d still maintain your original position in Tesla without allowing this one individual holding to dominate your portfolio and skew the makeup of your overall asset mix.

The bottom line: Investors who adopt a core-and-explore approach to their portfolio should determine a target percentage to allocate towards more speculative investments. Outsized returns from the explore side of the portfolio should be reasonably trimmed back to maintain this target threshold. This approach can reduce risk and allow profits from one investment to be reinvested back into the main core portfolio.

What about investment losses?

It makes sense to monitor your speculative investments and take profits from time to time, but this assumes your investments are indeed profitable. The same approach can be taken with any losing picks.

It’s reasonable to cut your losses on a bad investment rather than waiting for the price to recover. Remember, the investment doesn’t care what price you initially paid. Its future returns are all that matters.

Do you still have conviction that the investment will turn around? Or would you be better off selling it and putting that money into another investment with better future prospects? It’s helpful to think back to the rules you originally designed around your core-and-explore portfolio, and to reassess your capacity for risk. If you’re agonizing over a badly performing investment, maybe it’s time to sell those losing positions and trim back the percentage you allocate to speculative investments. 

Which account type is best?

Where do your speculative investments live: Inside your registered retirement savings plan (RRSP), tax-free savings account (TFSA) or non-registered investment account?

Selling speculative picks inside a registered account like an RRSP or a TFSA is simple enough from a tax perspective. Whether you’re taking profits or cutting your losses, you won’t need to report these trades to the taxman when the activity occurs inside a registered account.

That said, investors should still be mindful about carving out play money to speculate inside their RRSP or TFSA. That’s because if you sell an investment at a loss, you won’t be able to claim a capital loss on your tax return (a small consolation for making a bad bet).

Like many investors, you probably make a concerted effort to save and contribute to your RRSP and TFSA—and if you speculate with those contributions and lose money, then you’ve lost that contribution room forever. Not ideal.

Of course, trading inside of a non-registered account can trigger capital gains or losses, and the income is taxable. It can be difficult to stay within your risk threshold if you have an investment that’s in a large capital gain position and you don’t want to trigger taxes when you sell.

In this case, you’ll want to carefully manage your taxable investments to minimize any tax hit while also striving to maintain a risk-appropriate portfolio. Partially trim any outsized gains over a longer period to spread out the tax hit over several years instead of just one.

If you hold multiple investments in a taxable account, look for trade-offs between capital losses and capital gains. For example, an investment that’s in a $10,000 loss position can be sold to help offset an investment that’s in a $30,000 capital gain position. This process is called tax-loss harvesting, and it can be an effective way to manage your taxable investments and minimize taxes from year to year.

It’s easy to get carried away with the exploratory portion of your portfolio. Emotions like fear, greed and a desire to compete with other investors can be powerful and difficult to contain. That’s why it makes sense to design rules around your speculative behaviour. Determine what percentage of your portfolio you’re willing to play with, and set rules in advance on when to sell your winners and losers so you stay on target.

More about investing:

• What we learned about investing during a pandemic
• Where to hold investments for tax savings
• How to invest as a teenager in Canada

About Robb Engen, QAFP

Robb Engen is a fee-only advisor who will work with you to achieve your financial goals by creating a financial plan with actionable steps along the way.