I listened to the latest episode of the ChooseFI podcast, which is about financial independence (FI). The focus of this episode was on filing taxes, but there was a really interesting (and horrifying) story.
They told the story of someone who made massive profits in 2021 in the seven figures. I am assuming this isn’t including the numbers after the decimal place, which means he had gains of over one million dollars in 2021. I am also assuming it was a man, although I don’t know for sure.
But there’s a big problem. It sounds like he made this money trading options and now owes taxes on these realized gains. If he had done this in a retirement account, there wouldn’t be a tax issue. If he had made massive gains in stocks, he wouldn’t owe any taxes on anything that hadn’t yet been sold. But in this case, it sounds like he owes taxes on the million-dollar plus gains that he made.
But there is an even bigger problem. He says he lost these gains in 2022. So he now owes a massive tax bill of nearly half a million dollars, but he has since lost all of that money. And since the losses came in the subsequent calendar year, he can’t offset the gains with his losses. He will be able to claim just $3,000 (which in his case, is essentially nothing) for his 2022 taxes.
This is a nightmare scenario. He said in his post that he has a job with a decent salary, but this is still a massive blow.
It is almost as if he owes hundreds of thousands of dollars on a student loan, except in this case he didn’t even get a diploma to go with it.
This is an unusual example, especially with the high dollar amounts, but it is reality. I have no idea if the story is true, but it is still illustrative. It shows how absurd the tax code really is, and it also shows that you need to navigate it very carefully, especially when you have seeming success.
Interestingly, I played the options market at one time. Similar to the person in this story I just described, I did really well at the beginning. But my “doing well” was in a different league. I might have made enough paper gains to buy a new car (at prices from almost two decades ago) if I had sold at the perfect time. But I never realized the gains and lost most of the profit before the option expired. I ended up losing money in options overall.
Just like this guy, I mistook some lucky timing at the beginning for skill and didn’t take my money and run. The good news for me is that I didn’t have a tax bill to go with it, or not much of one. I remember it was a bit challenging doing my taxes with buying and selling options, but that’s it. I probably wouldn’t have minded paying significantly higher taxes if I had actually made massive gains and held them.
I’m not sure what the biggest moral of this story is. You definitely need to take a portion of realized gains and set them aside to pay your taxes on those gains. But beyond that, it is a good life lesson that you shouldn’t get greedy and to take a portion of your winnings off the table, so to speak.
A Bird in the Hand
I’m not sure why anyone would want to catch a bird, but the saying is still a good one. A bird in the hand is better than two in the bush.
I can’t imagine being this guy who made over a million dollars in gains and then lost it all in such a short period of time. Assuming the story is accurate, he knows it was a big mistake, but it is an expensive lesson to learn. Worse, he now owes the IRS a huge amount of money.
I understand the urge to let a good thing ride. I think the biggest mistake that most investors make is that they think of it as an all or nothing game.
Let’s say you bought 100 bitcoins back when Bitcoin was trading at $10 per bitcoin. So you “invest” $1,000 in bitcoins, and now it has skyrocketed in price. If you had sold when it was at $65,000 near its all-time high, you would have made $6.5 million (less the initial $1,000).
What if you had sold when Bitcoin hit $1,000? That would have been a huge gain where the investment went up 100 fold. You would have pocketed $100,000 (less the initial $1,000). And yet, you would have been mad at yourself because you could have sold it at $10,000 per bitcoin or $40,000 per bitcoin.
You don’t want to give up your opportunity to hit a homerun on a speculation, but you also don’t want to be stupid and risk it all.
I have had similar circumstances. I have owned both Apple stock and Amazon stock in the past. I made gains on both. If I had held them both longer, I would have made massive gains. I think the Amazon stock would be worth something around $100,000 now for a pretty small investment back then.
The obvious solution is to take profits off the table while letting some of it ride. The guy who lost all of his profits (and now owes taxes) trading options probably should have taken at least half off of the table at some point. That would have paid for his taxes and left some money in the bank.
I should have sold off half of my Amazon and Apple stock and let the rest ride for a while.
I don’t know anybody personally (that I know of) who has become really wealthy due primarily to investing. There are many “millionaire next door” stories of people who saved money for 30 years and became quite wealthy by investing the savings, but the savings were early and significant. It’s not like someone turned $1,000 into $2 million.
I have heard stories about people who have struck it rich almost overnight through speculating. The problem is that these stories tend to not end well. Just like the speculator referred to on the podcast, they mistake luck for talent. They get greedy. They think if they turned $5,000 into a million dollars so easily, then they can turn a million dollars into 10 million dollars. They don’t take some of their profits off the table.
Given that I know of nobody who has become wealthy quickly through investing or speculating, I tend to focus more on protecting wealth and growing rich slowly. If you want to become rich in a short period of time, you have a better chance with starting a business.
For investing, I recommend a substantial portion of one’s financial investments to go into a permanent portfolio, or something similar. It is the safety money. I think it is fine for people who want to speculate to take a portion of their wealth and allocate it to speculation. But their speculative play money should be strictly limited to this. It is money you can afford to lose.
I have done all kinds of investing. As mentioned, I have traded options and individual stocks. I have bought my share of mutual funds. I have shorted the market and I have bought trendy stocks. I have bought penny stocks.
Of everything I’ve done outside of the permanent portfolio, the two best financial investments I’ve made are buying gold investments around 2001 and paying extra towards the principal on a mortgage with a 4.25% rate.
Sure, I’ve had individual stocks that have done well, but I have to look at the totality of things. I can’t count the gains from Amazon and Apple stock and not include the losses from other individual stocks. I can’t count the gains in trading options without counting the losses that ended up exceeding the gains.
I’ll still occasionally speculate, but not to the degree I once did. And even the speculations are usually providing some diversity for my overall portfolio.
The point is that conservative investing is underrated. I think it is always good to have a good portion allocated to slowly growing wealth. You will likely find that getting rich slowly is a better bet than getting rich quickly when it comes to investing.
If you do speculate and happen to hit a homerun, take some profits, and not just because you have to pay your taxes.