THEY SAY THAT
Unfortunately, for many of us, timing trades comes down to dealing with the government's antiquated and completely detrimental tax code. It's an embarrassment that the tax code, especially the part that deals with buying and selling securities, is almost impossible for many Americans to keep up with. Indeed, most of us not only pay taxes, but pay an accountant to tell us just how much tax we have to pay. No political party is without blame.
Taxes put us at an immediate disadvantage. If you buy XYZ at $50 and it goes to $60, you've made $10 a share, or a 20% return, right? Wrong.> If you sell the shares within one year of purchase, your gains will be taxed as ordinary income, immediately lopping off anywhere from 15% to 39% of your profit. Even gains on securities held over one year can be taxed at a suffocating 28%.
And while we are forced to pay taxes on all of our capital gains, both short and long term, investors are permitted to deduct only a portion of their losses (up to $3,000 a year). In effect, your winning trades aren't as big as they appear, while your losing trades are even bigger than they appear because the tax benefit of claiming losses is capped, but the tax penalty of claiming gains isn't. In gambling parlance, the chips are stacked against us from the start. That's the thanks investors get for being brave enough to take a risk.
But even more than simply extracting the levy, the capital-gains tax does a huge disservice to all investors, primarily because it distorts economic decisions. In the real world, where both businesses and consumers benefit from the free flow of capital, there's no difference between holding a stock for 364 days or 366 days. But in the government's world, where arbitrary holding periods and price caps are the norm, investors must game not only the market, but the system as well.
Indeed, millions of people have lost money by neglecting to sell stocks they probably should have. Why? Because they wanted to avoid paying the taxes. Now, with even the seemingly conservative S&P 500 down over 20% from its peak, many are finally throwing in the towel. They're still paying taxes, mind you they're just paying it on a significantly smaller pile of gains. One way or another, Uncle Sam gets paid.
Because the market moves on its own schedule, and not that of Washington bureaucrats, I am a strong believer that you need to focus on trade management first, taxes second. The only reason to invest in anything is to make money, and at the end of the day, capital gains are something we want to have.
So when it comes to timing in your own portfolio, tax ramifications are a factor, but not the only factor. Your hesitation in closing a profitable trade shouldn't be because of the taxes, but because of the possibility of missing out on continued upside.
So what's a good time to sell a stock? And how do you know which one of your holdings to sell?
Like a doctor, I am constantly checking my portfolio's vital signs. And when my account's value is dropping, it's the only symptom I need to see before prescribing some changes. Losing positions have a tendency to stay losing positions. And although many investors like to wait until the end of the year before selling their losing positions, you should consider cutting a loss while it's still a manageable one. While the government forces us to watch the calendar, the fact is that a loss is a loss. So why put off the inevitable?
In fact, by waiting until the end of the year, you might even be making a bad situation worse. For example, consider Priceline.com and AT&T, two of last year's well-known loser stocks that it seems everyone was selling during 2000's end-of-year "tax-loss season." Both sagged steadily from March 2000. But if you held on, clung to hope and didn't sell until the year-end rush, you really took a beating. Bad enough that Priceline plunged from a high of nearly a hundred bucks into the single digits last year but between Nov. 1 and the last trading day of the year alone it plummeted from $6.84 to $1.31, a loss of 85%. Similarly, Ma Bell dropped from $22.31 on Dec. 13 to $17.25 on Dec. 29, a loss of 36% in 11 trading days. On the other hand, both are up sharply this year. Indeed, once all that tax-loss selling is through, it's usually a time to think about getting right back in.
|The Year-End Rush to Lose|
|Data from March 1, 2000 to Jan. 1, 2001
Ah, but the government makes it costly for you to do that. The wash-sale rule, another seemingly arbitrary piece in the jigsaw puzzle known as the tax code, stipulates that if you want to claim a losing trade as a taxable loss, you can't repurchase the stock until at least 30 days have passed. That's another argument for taking the loss early: You're getting that clock running as soon as possible, so if you're feeling bullish, you can get back in all the faster.
There's another way to keep your overall position while still realizing the loss. You can buy a similar, but not identical, security. For example, if you're bailing out of some QQQ's, you might go long a tech fund, or some individual big-cap Nasdaq stocks, or a tech-focused exchange-traded fund, or ETF, such as the iShares Goldman Sachs Technology Index fund, the iShares Dow Jones US Technology Sector fund or the Technology Select SPDR fund.
Alternately, you should consider sitting on the sidelines and waiting for some strength. Stocks move in trends, and when a position is losing money, that's enough of a reason to consider getting rid of it. Trading is just like barhopping. You've got to go where the action is.
But what about the winners? There's always a bull market somewhere, and while the big-cap indexes have been struggling year-to-date, there are a number of stocks actually doing quite well. So how should you decide whether to sell a winning trade? And what's the best type of order to use when you finally do decide to cash in your chips? How to hold 'em, fold 'em, walk away and run...one week from today.
Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund>.