Selling stocks is more complicated than buying them. In addition to trying to make a profit, it is necessary to consider the tax consequences of a sale. The sale of a stock may push the investor's income into a higher tax bracket. The profit on the sale of a securities that have been held for one year or less are considered short-term capital gains that are taxed as ordinary income. The gains from stocks that have been held for more than a year are considered long-term gains that are usually subject to a lower federal tax rate.
When a stock has risen and then starts to decline in value, an investor is faced with the dilemma of risking the loss of some or all of the gains while holding the stock for over a year to get a more favorable tax situation. In general, it is better to pay taxes on stock gains rather than sell at a loss.
One of the hardest decisions that an investor has to make is what to do when the price of a stock starts losing value shortly after its purchase. Is it better to hold the stock when its value continues to drop hoping that the value will eventually recover? Or, is it better to sell the stock at a moderate loss to avoid losing a greater amount by continuing to hold? Many investors will sell a security when its value has dropped by 5 or 10 percent. These decisions have to be made based on the volatility of the stock and the investor's tolerance for risk. Stock brokers allow investors to place stop-loss orders to sell at a predetermined price and protect profits or limit losses.
How to decide whether it is time to sell
Ask yourself three questions: 1) Would I buy this stock today? Examine your portfolio and for each stock determine whether you would be willing to buy it at its current price. If the answer is no, consider selling. 2) What was my reason for buying? Remind yourself why you bought the stock. If those reasons no longer apply, it may be time to sell. 3) Are there better options? Look at a few other investments and compare them with your holdings. Would it be more profitable to sell your current stocks and replace them with better performing stocks? If so, you may want to sell. In general, you should sell underperforming assets that no longer fit your investment strategy. Also, you should consider selling your lowest rated stocks and acquiring higher rated stocks to improve the quality of your portfolio.
Selling at a loss
An investor who sells a stock that has been losing value is prevented from claiming a loss if he shortly thereafter repurchases the stock. This is called a "wash sale" and the Internal Revenue Service (IRS) prohibits a taxpayer from claiming a loss on the sale or trade of a security, if within 30 days before or after this sale the investor buys a "substantially identical" stock or security.
The tax laws influence greatly the strategies for selling stocks. Gains from stock sales sold at a profit are fully taxable. Capital losses can be used to offset capital gains, but if the losses exceed the gains, a maximum of $3,000 can be deducted against other sources of income. The rest of the losses have to be carried over to the next tax year. Many investors review their portfolio holdings in November and December to sell stocks with losses and reduce the tax liability of the stocks sold at a gain.
There are times when the whole stock market loses value. This is generally the result of unstable market conditions as illustrated by these three examples.
The 2000 Dotcom bubble: During the dotcom bubble, the value of Internet companies (.com or dotcom) grew exponentially between 1995 and 2000. Over the next two years values dropped by more than 76 percent.
The 2008 Lehman Brothers bankruptcy: The collapse of one of the world's biggest and most successful banks caused the firm's stock to plummet by 93 percent. The financial industry suffered great losses and the government had to intervene to stabilize the mortgage industry.
The 2020 COVID-19 corona virus pandemic: A new, highly contagious and deadly virus appeared in China. China imposed severe quarantines that closed factories and disrupted supply lines. As the virus spread, other countries limited international travel and closed service industries to enforce quarantines. The stock market crash in March 2020 included the three worst point drops in U.S. history.
When the market conditions are unstable and the market downturn is likely to be long, it is advisable to sell all equities, keep all assets as cash, and prepare to pay estimated taxes.
Selling stocks is an Emotional Roller Coaster
Selling stocks can cause elation or depression. We feel good and we think that we are very smart when we sell at a profit, but if a stock continues to climb after we sold it, then we may regret having sold too soon instead of holding longer to make a bigger profit. Selling a stock at a loss is traumatic from the outset and we may hesitate to sell because we hope that the value will increase even while the value continues to drop. When a stock loses value, not only do we lose our investing capital, we question our decision about why we invested in that stock in the first place, and we feel dumb. Selling at a loss undermines our confidence and we start thinking about the signs we missed that could have caused us to sell sooner and taken a smaller loss. Sometimes, bad news come suddenly, like the crashes of the Boeing 737 MAX or the quarantines of cruise ships. In such cases it may be impossible to avoid losses, so it is not unusual to feel anger and frustration.
Required Minimum Distribution (RMD)
Once you reach age 70 1/2, the IRS requires you to take money out of your retirement accounts. These mandatory withdrawals are called required minimum distributions (RMDs). You must take an RMD for Individual Retirement Accounts (IRAs), Simplified Employee Pension (SEP), and other types of accounts specified by the IRS, except Roth IRAs. If your withdrawal for any given year is less than your RMD, the IRS may impose a 50% penalty on the shortfall. The amount of the RMD is calculated from actuarial tables that divide your account balance by your life expectancy. If you have a life expectancy of 20 years, the RMD is your account value divided by 20. If your account balance is $500,000, your RMD will be $25,000 and you will have to pay tax on that amount. Once you transfer the $25,000 from your IRA account to a bank or brokerage account, you will need to pay the IRS $7,500 if your tax bracket is 30%.
If your IRAs are fully invested in stocks, what should you sell? First, get rid of stocks with bad performance since retaining these stocks will just decrease the value of your investment. Next, sell your stocks with the least growth and retain those with good performance. In this way, your retirement account will continue to increase in value until the next year when you have to make another mandatory withdrawal. You basically have a whole year to think about what to sell to get the cash for the RMD. The market will go up and down during this time and it is better to sell when the market prices are high because you will have to sell fewer shares to meet the RMD than if you sell when the market prices are low.
Tools that you can use
There are various tools that can be used to analyze stock movements. The tools make it easier to decide when to buy or sell a stock by eliminating the short-term fluctuations that make it difficult to understand whether a stock is increasing or decreasing in value over a longer period of time.
BigCharts.com and Yahoo Finance offer free charting services for stocks. The charts can be customized in different ways. These charts show the stock price of IBM for a 3-month period with a candlestick chart, 9- and 18-day simple moving averages (SMA) and Bollinger Bands.
The Candlestick Chart is a style of bar-chart that describes price movements of a security for a designated span of time. Usually, each bar represents the range of price movement for one day. The bar corresponds to the opening and closing values of the security. A green bar indicates a gain, and a red bar indicates a loss. The green bars have the opening price at the bottom and the closing price at the top. The reverse is true for the red bars. Thin lines that extend above or below the bars indicate the range of values of the stock during that day.
The Simple Moving Average (SMA) is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. The short-term averages quickly respond to changes, while long-term averages react more slowly. In these charts, you can see that the moving average for 9 days, SMA(9), is more jagged than the moving average for 18 days, SMA(18). The SMA smooths out the daily variations to provide a simplified interpretation of the trend.
The Volume shown under each chart indicates the number of trades for the security during each day. These charts show a high volume on October 17, 2013 when the IBM stock price dropped significantly.
Bollinger Bands indicate the volatility of a stock by showing the standard deviation above or below a moving average. In general, when the bands lie close together, a period of low volatility is indicated. When the bands expand, an increase in price volatility is indicated. Some traders buy when the price touches the lower Bollinger Band and sell when the price touches the moving average in the center of the bands.
Charts provide insights that may be used for many trading strategies. When a stock rises and then falls, the top of the curve is called a "resistance" level. When a stock drops in value and then rises, the bottom of the curve is called the "support" level. Some traders will buy when a stock starts rising from a support level and will sell part or all of the stock as it approaches a recent resistance level. Some traders will use stop orders to sell the stock in case its value declines below a certain value to limit the loss of capital.
Long-term investors buy stocks based on fundamentals and disregard stock value swings due to general market conditions that do not affect the intrinsic value of the stock. The stock of companies that produce popular, good-quality products generally appreciates in value in the long term. To maximize profits, it is better to own stocks of companies that increase in value faster, but we often know this only in retrospect.