Sunday, January 16, 2011

How Do You Know When It's Time To Say "Goodbye"?

Yahoo! Finance has an article on their site entitled 5 Bad Financial Decisions and How to Recover which makes for an interesting read.  There was one point in particular that piqued my interest regarding hanging on to an investment for too long:

"Just like a boxer needs to learn how to take a punch, investors must eventually learn to take a loss. Not every investment will be a winner. It takes emotional discipline to recognize the mistake and cut your losses."

The article goes on to suggest that, rather than holding onto a loser investment, one should sell the investment and take advantage of the tax benefits of a capital loss.  For those who aren't aware, if you sell a stock or other investment for a profit, you must pay capital gains taxes on your profit.  Likewise, if you sell an investment for a loss, you can use the loss to offset any capital gains you had during the year.  For instance, if you sold stock A for a gain of $1000 and sold stock B for a loss of $1000, your net capital gains is $0.  Thus, you would not pay any capital gains tax.  In addition, if your loss exceeds your gain by less than $3000, you can deduct the loss from your income.  If sold stock C for a loss of $1000 and your taxable income is $50,000, you only have to pay taxes on $49,000 of your income.  If your capital loss is greater than $3000, you can carry over the loss into future years.

[As always, consult your tax advisor for more information on how a capital loss might impact your specific tax situation.]

Getting back to the subject at hand, the advice that the article gives is sound except for one fact:

How do you know if something is a loser investment?

One of the other "bad financial decisions" the article highlights is letting short term thinking ruin your long term financial plan:

"There are active management strategies, in which a preset event triggers a decision to buy or sell. And then there is random flailing. That would be the strategy in which investors randomly sell positions after losing money and then buy back in after the market recovers."

The only problem, according to the article, is that by the time things are better, you might have missed out on the market recovery.

Obviously, the two pieces of advice (selling loser investments for the tax write-off and holding onto loser investments until things recover) are in conflict.  How does one know whether it is better to sell or wait out the storm? 

On one hand, you have Circuit City.  Circuit City went into a downward spiral due to poor management decisions throughout the 2000's, resulting in the company going out of business in 2009.  Today, Circuit City stock essentially is worthless, and there is pretty much no chance that the stock will ever be worth more than zero.  Therefore, this would be a situation where "selling" for the tax writeoff makes sense (actually you would just take the write off since nobody is going to buy a worthless stock).

On the other hand, you have something like an S&P 500 index fund.  Back in March 2009, when everyone thought the sky was falling, the S&P 500 had been beaten down by the financial crisis.  However, as we all know, it has bounced back quite well from those dark days.  Therefore, this would have been a situation where staying the course made the most sense.

The only problem is that most people have trouble distinguishing between the two situations.  If you remember the first quarter of 2009, people were panic selling their stocks in droves.  There were financial "experts" who were predicting further drops in the stock market, and they recommended getting out while the getting was good.  Of course, those who sold based upon emotion and took their tax writeoffs ended up missing out on quite a nice bull market.  You would have been much better off staying the course.

Yes, if you have an investment which you know is a loser, by all means sell it for the tax writeoff.  Just make absolutely sure you know how to distinguish the true losers from the short term drops. 

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