What You Need To Know Before Selling A Stock

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Have you ever been tempted to sell shares and lock in gains when stocks in your portfolio rose?

Have you ever impulsively sold stocks that were nosediving because you were afraid they would fall further and lead to bigger losses?

If so, here’s what you need to know before selling a stock.

Selling A Stock Has Bigger Tax Implications Than You Might Think

Paying taxes on gains, especially short-term capital gains taxes, can drastically lower your portfolio net worth over long time periods compared to a buy-and-hold strategy.

When you are selling a stock that has risen in price from the time you bought it in a brokerage account, you will need to pay taxes on the gains. The impact of these taxes over time is much bigger than most investors realize.

To understand just how much regular tax payments on gains hurt portfolio growth over time, imagine going back in time when a 30-year old Warren Buffett had a goal to build enormous wealth.

The year is 1960 and young Warren Buffett is looking to the future imagining how to become the most successful investor of all time. He calculates how much money he will make if he can earn 15% each year for the next 60 years.

Although we don’t quite know when Mr. Buffett made this calculation, it is clear from his investing method he ran the numbers at some point because his investing approach resulted in him becoming one of the richest investors in the world.

Let’s imagine back in 1960 Mr. Buffett compared two portfolios growing at 15% annually. One portfolio is taxed each year by Uncle Sam at the rate of 30% on short-term gains, and the other is not taxed until 60 years later at a long term capital gains rate of 20% (we’re making these numbers up as the year is 1960!).

Although this is a hypothetical example, it is helpful to compare the effect of taxes over time.

You can see in the table below that holding a portfolio growing at 15% each year and not paying taxes until the final year results in $100 growing to an astounding $381,217.

By contrast, paying taxes on gains each year results in the second portfolio growing to $61,576, meaning that the cost of paying Uncle Sam regularly is to amass a portfolio about one sixth the size it otherwise could be!

YearBuy-and-holdTax LiabilityBuy-and-sellTax Liability
11000100
1035202728.4
201,423080424.8
305,75802,38073.4
4023,29207,038217.0
5094,231020,818641.9
60381,217061,5761,898.5

While paying taxes by selling winners regularly can hurt portfolio growth over the long term, it is generally a bad idea to hold onto a stock simply to avoid paying taxes – especially if it is fundamentally weak.

Nevertheless, the next time you are tempted to sell a stock simply to lock in gains, take a step back and think about how the cumulative effect of paying taxes regularly on portfolio gains can severely hinder the growth of your portfolio over the long term.

TAXES ON STOCKS IN THE RED

Stocks in the red – those that have fallen in value and are underwater – will not be subject to taxation in a brokerage account.

But selling losers can help you offset taxes owed on winners. You can offset capital gains on winning stocks by selling losers in a process known as tax loss harvesting.

Many of the leading robo advisors, such as Wealthfront and Betterment, specialize in tax loss harvesting.

Not only do these robo advisors manage your portfolio automatically but they harvest tax losses so well that in some cases the benefits can entirely offset management fees over time.

>> Related: How To Pick The Best Robo Advisor

TAXES ON RETIREMENT ACCOUNTS

If you are selling a stock in a retirement account, such as a 401(k) or IRA, taxes are not something you need to worry about until you start taking withdrawals.

You can buy and sell as often as you wish without concern for the tax impact. However, you will still pay commissions when buying and selling.

>> More: Is A Roth IRA Better Than A Traditional IRA?

Am I Selling A Stock Too Soon?

Nobel prize winning research shows that it feels better to lock in gains when stocks rise in value than to risk them falling back to breakeven or worse. When you understand your own cognitive biases to make irrational investment decisions, you can consciously make better investment choices.

SELLING A STOCK BASED ON COGNITIVE BIAS

A Nobel prize winning theory, called Prospect Theory, states that people hate losing more than they like winning.

So, how does Prospect Theory affect your investment decision-making?

It turns out that by fearing losses more than we enjoy gains, we humans have a tendency to sell winning investments too soon.

It feels good to lock in profits and bank gains by closing out positions. But what feels good short term can hurt us over the long term.

As John Maynard Keynes once stated:

“The market can remain irrational longer than you can remain solvent”

Another way of saying this is that stocks can move further than you ever imagine possible.

As stocks rise, bearish voices clamour to rationalize why further upside is limited. But the old adage “stocks climb a wall of worry” has become famous because share prices often rise in spite of the doom and gloom prognostications of skeptics.

Selling a stock too soon is a common stock trading mistake but once you understand Prospect Theory, you become more aware of the risks of making irrational investment decisions based on a human cognitive bias.

SELLING A STOCK BECAUSE OF VOLATILITY

When fear grips investors, stock market volatility can spike higher and catalyze impulsive reactions. Buying and selling a stock because of share price swings is a common trading mistake, so how do you improve your chances of side-stepping these pitfalls?

First, ask yourself if anything fundamentally has changed? Is the stock rising or falling because the overall market has started to soar or a stock market crash is in full force?

If you buy a stock based on its share price, you may sell it based on its share price too. And if the overall market is soaring higher or crashing lower, your stocks will probably tag along for the ride.

But just because the S&P 500, Dow Jones Industrial Average, Russell 2000 or NASDAQ is rising or falling doesn’t mean the thesis behind why you bought a stock has changed. Maybe it has, but maybe the market swings and roundabouts are just noise to be ignored.

SELLING A STOCK BASED ON NEWS EVENTS

A news event about a stock you own may be important enough to warrant selling a stock, but to know one way or the other with certainty you should understand how to research stocks.

If a company missed earnings this quarter or management lowered forward guidance, nervous nelly shareholders may have a negative knee-jerk reaction and sell.

But if you understand how to research stocks properly, you will know how to distinguish fundamental shifts from news events that only have a temporary impact on share price.

For example, a company like Pepsi may miss earnings from time to time but if its brand value remains strong in consumers’ minds, its distribution network unaffected, its sales remain strong, and its market share resilient, the earnings miss may just be a temporary bump in the road.

>> MORE: What Are The Best Stocks To Buy?

Am I Selling A Stock
To Buy A Better Stock?

It is better to buy, at a fair price, a company whose intrinsic value is constantly increasing than to buy at a discount a decent company whose intrinsic value is not growing by much.

When you buy a stock, you miss out on another. But what if the other stock rises more than the stock you own? That is the opportunity cost you must come to terms with when you buy a stock.

When you see another stock rising in share price more, it doesn’t necessarily mean you should jump ship, sell your stock, and buy another.

Forget about share price for a moment, and focus on what the company is truly worth – its intrinsic value.

What you want to find are what Warren Buffett calls:

“Wonderful businesses at a fair price”

By fair price, Buffett means share prices close to intrinsic value. And by wonderful, he means that over time the intrinsic value of these companies will grow.

Perhaps it seems obvious, but this philosophy was not the original investing framework that Buffett used.

When he began investing, Buffett bought:

“Fair businesses at a wonderful price”

These were business trading below intrinsic value that had pretty good business models. By buying decent businesses at a discount to fair value, Buffett could make money when the share price rose but he learned that it’s much better to buy a business whose fair value is increasing too.

Greater long term wealth is accumulated by buying businesses whose intrinsic value increases over time than is amassed by buying businesses temporarily “on sale” in the market.

Should I Sell Stock Because
My Portfolio Is Not Balanced?

Make sure your overall portfolio is balanced and in alignment with your overall financial goals and risk profile, especially when one stock appreciates in value so much that it skews the weightings in your overall portfolio mix.

When you start investing, you may have your money spread across a number of stocks. But as time goes by, some stocks soar. Maybe you bought Facebook or Google when they came public.

When a company grows its intrinsic net worth fast, it generally doesn’t take too long before its share price reflects the increased value.

But when one company in your portfolio grows much more rapidly than others, your overall portfolio can fall out of balance.

It is tempting to hang on to a winning stock but if it becomes such a large part of your portfolio that swings in its share price significantly impact your overall portfolio, then it may be time to pare back the holding so your overall portfolio is aligned with your risk profile and financial goals.

To avoid the tax impact of selling your stock, you could look to hedge it from time to time during downturns using married put options strategies.

Another way to hedge somewhat and also generate income is to sell calls against your shares as part of a covered call strategy.

>> Related: Learn How To Trade Options

Will Selling A Stock
Trigger A Wash Sale?

Avoid selling a stock if you plan to repurchase it again within 30 days, otherwise it triggers a wash sale.

As a calendar year end approaches, it becomes tempting to sell losing stocks in order to generate tax losses that can be counted against winners you have sold.

But selling a stock and buying it again a short time later – within 30 days – triggers a wash sale, meaning your tax losses cannot be counted.

The IRS views selling a stock in order to capture tax losses and subsequently repurchasing it within 30 days as an attempt to “game” the tax system and disallows it.

To “get around” this tax rule, some robo advisors, such as Wealthfront, provide advanced tax-advantaged portfolio management strategies, such as Direct Indexing, whereby losers are sold and similar (but not the same) securities are bought.

By so doing, tax losses can be counted while reducing the risk of missing out on upside share price movement in a given sector.

WEALTHFRONT SPOTLIGHT
wealthfront brokerage trading system robo advisor

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via Wealthfront secure site

Plan On Selling A Stock
Before You Buy

Whether selling a stock or buying a stock, dollar cost averaging is a smart strategy.

Timing the market well is really hard. Any day trader who has been around the block will be able to share stories of regret about buying too soon or selling too late.

How many Twitter stock traders wish they bought or sold earlier? How many AutoZone stock traders have suffered from the swings in its share price?

The reality is nobody can time the market perfectly, so looking back at what should’ve, could’ve or would’ve been only wears investors down psychologically.

Rather than choose an all-or-nothing strategy, much better to build up a stock holding by dollar cost averaging in.

When you dollar cost average, you buy shares slowly and steadily over time until your full position is owned.

You won’t ever buy at the bottom, but equally you won’t ever buy at the peak when the risk is highest.

Before a first purchase is made, you should have your plan to sell the stock.

Without a strategy to sell, you are more likely to succumb to emotional trading and a knee-jerk reaction.

A simple plan to sell is to pick a share price and dump your shares when the price is hit.

But many traders have suffered from picking a big round number as a target only to see the share price come within a few pennies of the target yet fall short before cratering lower.

To avoid the heartache of “almost” selling for a profit, and snatching defeat from the jaws of victory, consider dollar cost averaging when you sell too.

Your decision to sell a stock doesn’t have to be binary whereby you sell all your shares at once.

Instead, you can decide to sell some shares consistently over a fixed time period, say a few weeks or a few months.

You will never sell right at the top by choosing to dollar cost average out but the chances are slim of consistently selling at the top anyway.

>> MORE: How To Short Stock

Be Smart When Selling A Stock

The long and the short of selling a stock is to be smart about the steps you take before pulling the trigger:

  • Plan when you will sell before you begin buying
  • Consider dollar cost averaging in and out
  • If you plan to sell, avoid buying within 30 days or it will trigger a wash sale
  • Know your opportunity cost when you buy or sell a stock
  • Calculate the tax impact both short-term and long-term of selling a stock
  • Verify your decision to sell is based on a fundamental reason

What factors do you consider when selling a stock? What investing tips and trading lessons can you share? We would love to hear from you in the comments below.

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