2012-03-19 12:03:25
April 30 2007 | Filed Under Retirement , Stocks
The vast majority of financial literature is concerned with when to buy a stock and how to get a deal. The assumption seems to be that the time to sell is self-explanatory. The truth is that selling is just as important and intensive an operation as buying. In this article, we will take a look at the main points you should consider when selling an investment.
Reasons to Sell
In general, investors want to offset gains until they can realize them in a lower tax bracket. When you are at your earning prime, for example, investing income will be taxed more stringently than when you are retired. Consequently, there are only a few reasons to sell before that time.
The most common reason is to adjust your portfolio. There are many reasons that a portfolio might become unbalanced or inappropriate for your investing goals. This might be a lifestyle change like marriage, divorce, retirement, the birth of a child or merely an accidental concentration of capital in one sector.
Putting all of your stocks in one sector - or even putting all of your money into a certain risk level of investments - is a dangerous game. Diversifying generally negates the chance that you will lose everything at once, but you have to be careful not to over-diversify, which will hamper your portfolio's growth. When your portfolio needs to be diversified or, in the case of over-diversification, refocused, the goal is to incur as few fees and taxes as possible while making the changes. We will look at how to do that shortly. (To learn more, see The Dangers Of Over-Diversification and The Importance Of Diversification.)
The other reason to sell an investment is to free up capital - whether to make a down-payment on a house, finance your new business, pay for major surgery, take a vacation, etc. The best way to free up capital is to realize losses to offset your gains. If you have two investments - one that has experienced gains and another that has suffered losses - you can sell them both to avoid having an overall profit that is prey to capital gains tax. (To learn more, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax and Capital Gains Tax Cuts For Middle Income Investors.)
There are a few conditions that you have to satisfy to do this:
The stock or securities that you are selling have to have been in your ownership for at least a year. (Although there is a rate schedule for both long-term and short-term gains and losses, the long-term rates are more favorable and less complex.)
There is a limit to the net losses you can post in a given year. If you are over the limit, you have to carry over the losses to later years (complicating your tax forms and postponing the value of the write-off).
You have to conform to the wash sale rules. If you buy back the investment you sold for a loss within a 30-day period, it negates the deduction - after 31 days, you are fine. You can dodge this by buying a comparable investment if you don't want the money sitting idle. Be careful to mind the rules when using this strategy. (For more insight, see Selling Losing Securities For A Tax Advantage and Using Tax Lots: A Way To Minimize Taxes.)
If you really need the money, don't let taxes keep you from selling. If your only other option is a loan, then you are better off to eat the tax, curse the government and spare yourself years of high interest debt payments. In terms of raising capital, you are better off (as far as taxation is concerned) to sell large holdings with modest gains rather than smaller holding that have had larger gains. Make sure to calculate how much you will be paying in taxes and fees, and check that you will have the amount you need when all is said and done.
Reasons Not to Sell
Selling because of a bad quarter or a rough year is one of the worst reasons to sell an investment. Assuming that due diligence has been done and the investment is sound, bad quarters are when you should be buying more. Dips in the price of a solid company can be caused by any number of factors unrelated to the company's performance, such as a sector-wide correction, a bear market, rumors or investor panic - just to name a few. If you react after a bad quarter, you are reacting to old information - the damage has already been done and repairs are underway. A little bit of stoicism will go a long way toward strengthening your portfolio and your skills as an investor.
Another dubious motivation to sell is to unload or cash in on inherited investments. Investors often feel less favorable toward these investment because they didn't choose them and, as a result, react more harshly to price fluctuations than they would in other circumstances. When you inherit shares, however, the previous capital gains are erased. This means that even if the shares are stagnant, you still have a tax-free source of capital that you paid nothing for. If they go down in value, you will get a tax write-off along with the capital from selling them. If they go up, you have nothing to complain about. Just because you have a cash cow, however, doesn't mean you should slaughter it. Hold on to inherited shares until you need them or pass them on yourself. (To learn more, see Inherited Retirement Plan Assets Part 1 and Part 2.)
The Mechanics of Selling
The first thing to look at when selling an investment is the fees you are going to have to pay. If you use a broker or hold the shares at a high-end brokerage firm, there is nothing stopping you from transferring them to a discount brokerage firm to limit your fees and increase your gains.
Taxes are your next concern. We have already discussed balancing out your gains and losses to minimize your taxes. The last rabbit to come out of the hat is the art of specifying shares. Sales are FIFO, or first in first out, unless otherwise stated. For an investor with a stable portfolio, the FIFO method of selling can be disadvantageous from a tax point of view. You always want to sell the shares that you paid the most for and defer realizing the larger capital gains on cheaper shares for as long as you can.
Let's say that you have a clockwork portfolio where you buy 50 shares of a fictional firm called Harry's Edible Life Preservers Inc. (HELP) every year. Over the course of four years, you pay $10, $15, $20 and $15 per share, respectively.
Suddenly, you need $1,200 for an emergency and it just so happens that Harry's shares are at an all-time high of $25. You decide to sell 50 shares. By selecting the shares you paid the most for - the $20 ones - you can lessen the amount of capital gain and, as a result, the amount of tax you pay. To do this, you have to identify the shares by the date of purchase, or the purchase price when you placed your order. Once again, you want to keep the shares that have gained the most for as long as you can, then you can cash in when you retire or have a tough year. By the way, shares of mutual funds aren't taxed like stocks, but through a completely different system of average cost method (ACM), so unfortunately you can't employ the same technique with mutual fund assets. (For more on this topic, see How do you calculate the cost basis for a mutual fund over an extended time period?)
Conclusion
Selling an investment is like buying one - you have to make sure it is in line with your investing goals and then do your due diligence. Once you have decided to sell an investment for the right reasons - either to balance your portfolio or free up needed capital - the challenge becomes minimizing fees and taxes. Your fees are best dealt with by finding a good discount brokerage to work through, and your taxes can be kept in check by simultaneously realizing gains and losses as well as specifying shares. Investing is not just about knowing when to sell, but why and how to sell.
by Andrew Beattie