A guide to selling stocks - Part 2

The theory of selling stocks is pretty simple, but it gets complicated when emotions and taxes come into the mix.

In Part 1 we saw that, in theory, the question of when to sell a stock is just the flipside of when to buy: you buy a stock when doing so improves your portfolio (by making it more undervalued and/or giving it a better balance) and you sell for exactly the same reason. But in practice the selling decision is much harder because it’s complicated by all the emotional baggage you’ve collected during your period of ownership and the thorny issue of tax.

We’re not able to advise you on tax matters but, to understand the impact that tax has on selling, you need to compare the funds you’ll be able to reinvest in a different opportunity (or hold in cash), after paying costs and taxes, with what you’ve got at the moment.

If, for example, you’re in the 46.5% tax bracket and you’ve held a stock for more than a year (so that it qualifies for the 50% personal capital gains tax discount) and it has doubled, then you’ll be liable to pay capital gains tax amounting to 11.625% of your holding if you sell it (a half, times a half, times your marginal tax rate). So, when you compare your current investment to any alternatives (or cash), then those alternatives will need to make that much better returns to make the switch worthwhile.

Against this, however, you need to bear in mind that you will eventually sell the holding, so the tax will need to be paid at some point. And if the replacement opportunity genuinely offers higher potential returns, then it might make sense to take the tax hit now and move the money to where it is more productive.

Less tax less often

All things being equal, though, you’ll do better to pay less tax less often, and thereby have more capital working for you over the years. (You’ll notice that we’ve assumed you get your 50% capital gains tax discount from holding a stock for more than a year. If you hold a stock in your personal name and have profits, then it’s very hard to justify switching into something else before a year is up).

At the other end of the spectrum, it may sometimes make good sense to crystallise a loss to offset gains made elsewhere in your portfolio. These situations are always very dependent on the precise circumstances and it’s at this point that we’ll have to leave things to you and your tax adviser.

Always consider, though, the capital that you have working for you now, and the capital that you will have working for you after any contemplated transactions. If it’s much less, then you’ll need to be pretty confident about the extra returns obtainable from the new investments.

The issue of emotional baggage involves fewer sums, but it’s no less problematic for that. If a stock has performed spectacularly well, it’s hard not to get a little greedy or fearful that your gains will be wiped away. If a stock’s been a plodder, then you might become a bit bored. And if it’s been a disaster, you might be out for revenge. It’s safe to say that these emotional responses won’t help you assess whether a stock should keep its place in your portfolio, but being natural human responses they’re hard to shake off.

Rising stock prices can feel pretty good because, at the same time, they’re making you money and making you feel clever. We had to overcome some very warm feelings towards Caltex when we recommended selling the stock in Caltex: Time to Sell. It had done well for us and, after upgrading the stock to Buy in Caltex: A fuel’s errand our view had been firmly vindicated. But the soaring share price prompted us to make a fundamental reappraisal of the stock’s value, and we couldn’t justify the higher price.

We’ve also taken some hard looks at ASX and Seek (last reviewed in ASX Cut to Hold and Seek buys in Brazil and Asia respectively) as they’ve risen quickly, but each time we’ve come out comfortable that the stocks’ prices still make sense given their future prospects.

Stop losses do not stop losses

With falling stocks, on the other hand, you’re losing money and quite likely feeling like a prize ding dong. An easy way out is to operate a ‘stop loss’, whereby you sell a stock if it falls a certain amount. But, to put it bluntly, stop losses do not stop losses. They merely cause you to realise a loss when it has reached a particular level.

Stop losses are also flawed because they assume that a mistake has been made simply because of a fall in price—but the whole basis of value investing is that the market often gets the price wrong itself. If you bought a stock yesterday because you felt Mr Market was far too depressed about its prospects, then it’s unreasonable to expect him to become rational simply because you own the stock today.

When the business fundamentals don’t work out as you hoped, though, it’s a different story. It’s easy to go into denial, or even to become resentful or angry, but if a stock’s value has fallen below its price, then you need to get a grip on your emotions and sell.

We did this with SMS Management & Technology, for example, when we accepted in SMS Management: Result 2015 that our original investment case for the stock – of a cyclical recovery in overall work in the IT industry – hadn’t worked out. With the outlook for the industry continuing to deteriorate we made the difficult decision to sell SMS and its share price has since more than halved.

The final point to make is that it’s important not to beat yourself up too much about your mistakes. You will sell stocks too early and you will sell them too late. So will we. The name of the game is to be right more often (or for greater value) than you’re wrong. To do this you need to remain objective, and a quick way to lose your objectivity is to get hung up on past mistakes.

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