It rarely hurts to take some chips off the table

As Kenny Rogers once sang, “You gotta know when to hold ‘em; know when to fold ‘em.”

What he didn’t mention, however, was taking some chips off the table to protect your profits.

I learned that lesson through two friends who built a homebuilding company in South Carolina called Great American Homes. It did so well so fast that national competitor PulteGroup (PHM) bought it in 1997.

I believe my friends each pocketed $30 million – more than enough to build well-funded and diversified portfolios, set up funds for their kids and grandkids, and still live the good life.

But entrepreneurs usually focus on “the next big thing.” Once their noncompete clause with Pulte expired, they dove right back into the homebuilding business, achieving sales of:

So they thought even bigger, adding in landscaping and mortgage lending services, and building a beautiful new corporate headquarters. By the time 2007 came around, they were making $100 million easy!

Only to lose it all in the 2008 housing crash.

Their two largest construction lenders called in their loans. They had about 500 unfinished houses they couldn’t complete. And so they had to liquidate their entire business, leaving both men with negative net worth.

I’m not one to throw stones considering my own near-bankruptcy at the time. Those of us in the real estate world did what we did and suffered the consequences as a result.

Yet I can’t help but wonder where they’d be today if they’d taken more chips off the table after the Pulte deal instead of doubling down. That question permanently changed how I think about risk.

Which is why I’m growing increasingly concerned about the artificial intelligence craze.

About a week ago, I wrote an article titled Something Wicked This Way Comes about artificial intelligence.

It wasn’t and isn’t that I doubt AI’s capabilities. I truly believe it will transform just about everything we do by the time it’s done.

But that doesn’t necessarily justify how we're financing its buildout.

The amount of money Silicon Valley is spending on data centers, power plants, transmission lines, networking equipment, and the like is staggering. Morgan Stanley expects it to hit close to $2.9 trillion through 2028 – and that’s just on AI-supporting infrastructure.

Yet tech companies can really only afford half of that through their own means and traditional borrowing. That means they’re getting more and more creative about their funding.

As already established, I’m old enough to remember the 2008 housing market mess in vivid detail. And I can now recognize what got us there.

Real estate businesses and their backers got very good at covering up that they were spending more money than they could afford. They’d move risk around and package it differently, then convince investors the results were safe.

When they weren’t even close.

I’m not saying AI infrastructure is the next subprime crisis in the making. But I do believe the cards are stacking up in ways we might not be completely thrilled with in the end.

Consider the Japanese yen trade, a topic Stephen Hester wrote about two months ago.

In short, while equity volatility is compressed near multi-year lows, that currency is becoming more expensive. And since it’s the source behind one of the world's largest “carry trades,” it’s bound to change the leverage game.

Essentially, investors have been borrowing yen on the cheap, then deploying the resulting capital into higher-yielding assets like bonds, equities, private credit… and technology stocks. It’s worked for decades now as Japanese borrowing costs have stayed so low and the yen has stayed so weak.

But carry trades can unravel quickly and violently. As Japanese rates rise and the yen strengthens – even slowly – it’s putting pressure on leveraged investors.

The more pressure and the more leverage, the more investors could start losing money on both ends of the trade. Too often, it goes something like this:

Just like that, an orderly market turns chaotic.

While this might not happen tomorrow, next year – or ever, for that matter – I still think it’s better safe than sorry. So call me a negative Nelly or naysayer all you want.

I’m still pounding the table to say you might want to take some chips off it while you can.

Before I go any further, let me make myself clear: I’m not hitting the panic button.

So don’t go selling everything saying that Brad Thomas told you to. Because I didn’t.

What I am saying is you should think about reducing your exposure to heavily leveraged sectors like AI. In which case, there’s more than one way to do so.

Oftentimes, yes, taking chips off the table means selling part of your position. But it could also mean increasing the amount of cash you keep on the side, rotating from expensive assets into cheaper competitors…

Or even buying “insurance” in the form of puts.

Take the Invesco QQQ Trust (QQQ), an exchange-traded fund (ETF). Buying a six-month put on it gives you downside protection if the Nasdaq-100 suffers a meaningful decline during that period.

So if Big Tech fails to impress during its next two rounds of quarterly reports… if interest rates remain higher for longer, weakening investor enthusiasm… or if the yen carry trade begins to unwind…

You have some protection.

Think of it like homeowners’ insurance. You don't want your house to burn down. In fact, you'd much rather pay the insurance premium and never collect a dime. But if disaster strikes, you're glad you bought the policy.

Puts can serve a similar purpose for a portfolio. And they can offer another potential advantage for investors sitting on substantial unrealized capital gains: not triggering a large tax bill.

Consider a $1 million equity portfolio heavily tilted toward technology stocks with significant embedded gains. Selling a large chunk of those holdings might reduce your market exposure, but it could also create an immediate capital-gains tax liability.

Uncle Sam might appreciate that solution more than you do.

Instead, allocating, say, 1%–3% of the portfolio toward QQQ puts would mean spending roughly $10,000–$30,000 on portfolio insurance. If the Nasdaq keeps climbing, those puts could expire worthless and you'd lose the premium.

But that's the nature of insurance.

If technology stocks tumble, the puts can rise in value and help offset some of the losses elsewhere in the portfolio. And because you haven't necessarily sold your appreciated holdings, you may also be able to defer realizing those capital gains.

You're paying a known premium today to protect against a potentially much larger loss tomorrow – without necessarily creating a taxable event by selling your winners.

Of course, options and tax situations can be complex, and certain hedging strategies can have their own tax consequences. But used prudently, puts can provide investors with something particularly valuable when markets become expensive and uncertain: a way to stay invested while putting a price on their downside risk.

If you’re not substantially wealthy – or you simply don’t have a large portfolio with significant embedded gains – puts might not be your best option. Options involve costs and risks that aren't appropriate for every investor.

If you don't own a home, after all, there's no reason to buy homeowners' insurance.

But that doesn't mean you shouldn't protect what you do own.

Think of the alternatives as a form of “renters’ insurance” – simpler ways to take some chips off the table and reduce your exposure without making an all-or-nothing bet:

The point isn't to predict the next correction. And it certainly isn't to call the top.

It's to be prepared.

Maybe stocks correct 10%. Maybe we get a full-fledged bear market. Or maybe the bulls keep running and today's expensive market becomes even more expensive.

I don't know.

Nobody does.

That's why the proper market mindset isn't about fear or greed. It's about risk management.

Don't get crazy. Don't get reckless. Look at your finances, examine your positions, consider your tax situation, and make rational decisions that allow you to participate in the upside without exposing yourself to unnecessary downside.

Because investing isn't just about how much money you can make. It's also about how much you can keep.

As always, the first rule is to protect your principal. You don't have to leave the party. Just make sure you know where the exits are.

I suspect some of my old friends who went all-in on the housing market before the financial crisis would agree with that mantra today.

Happy SWAN investing,

Brad Thomas
Editor, The Wide Moat Daily