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When to Sell an Investment

Selling a lemon investment

I’m often asked when the right time is to sell an investment. There are actually two answers — a logical one and an emotional one. Let me explain by illustrating through one of the lessons in a course I teach.

I teach behavioral finance to CPAs (and confess I am one). I give the class the following situation and then poll them on what they would do:

You have been gifted $10,000 and decide to buy two stocks with it. You buy 100 shares of ABC at $50 a share and another 100 shares of XYZ, also at $50 a share. Thus you have $5,000 in each stock. Over the next three months, ABC declines to $25 per share while XYZ surges to $75 per share. You still have a $10,000 investment but ABC is worth $2,500 while XYZ is worth $7,500. If you have to sell one stock, which one do you sell?

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Roughly 75 percent of the class sells the winner, pocketing the $2,500 gain in XYZ shares. The fun begins when I tell them they made an illogical choice. I point out that the $2,500 gain is taxable while the $2,500 loss would result in a tax deduction. Even if one can’t use the tax loss now, it still has economic value in future years via a tax-loss carryforward. Remember that these are CPAs I’m teaching who are trained to be tax-efficient.

I then point out the behavioral biases going on in making this choice. Selling ABC at a loss is hard because, in our mind, the stock is anchored at our purchase price of $50 per share. Selling at $25 permanently locks in our mistake to purchase it in the first place, while holding on gives us the hope that it will someday turn around and we can at least get our money back. You can’t sell it and then immediately buy it back because the IRS wash rules would prohibit you from claiming the loss on your tax return. You must wait at least 31 days before repurchasing the same investment, if you want to claim the loss. On the other hand, selling XYZ locks in our 50% gain in three short months, not to mention our brilliance in selecting it in the first place, giving us permanent bragging rights.

So I challenge the class to consider that what most did was to trade an economic gain (lower taxes) for emotional well-being (locking in the gain and avoiding finalization of the loss). I get some pushback stating that all of this depends on why each stock moved, to which I respond in my typically tactless way that I disagree. ABC is really worth $25 a share while XYZ is worth $75 a share unless they know something the market doesn’t already know. In fact, some data supports a momentum factor in that there is a slight likelihood in the short-run for ABC to continue to decline and XYZ to continue to climb.

Do as I say, not as I do

For the most part, I practice what I preach. In my gambling (fun) portfolio, I sell my losers and typically keep the winners indefinitely. For my index funds (the vast majority of my stock investments), I sold my losers in 2008 after the stock market plunge and immediately bought similar (but not identical) index funds. Doing so allowed me to both avoid the wash rules and to keep disciplined by staying in the stock market. This is known as tax-loss harvesting.

But my editor snidely pointed out that in my last column I didn’t sell my gold after it plunged in the 1980s, and stayed at a loss for the next two decades. I hate it when he brings up great points! Sure, I could make some excuses, such as the high selling costs of gold coins back then or having to go to my safe deposit box and then to a coin store. But the bottom line is that I acted irrationally both in buying the gold in 1980 ( following the herd), and in keeping it while it had a loss ( anchoring). It’s at a gain today though it has not come close to keeping up with inflation.

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My advice

I often hear people say they haven’t lost money until they sell the investment, or that it’s only a paper loss. I would have to disagree with that as well. Unfortunately, those waiting for their Enron stock to rebound may have to wait a whole lot of forever. In investing, a sign you are doing the right thing is that it hurts. It hurts to sell losers, but deriving a tax benefit from doing so allows investors to make a little lemonade out of those lemons.

Photo: KenCameron/iStock

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