Let’s say, for example, you have no cash and you have to sell a current position in a stock in order to have the $10,000 cash needed for a new purchase. You can sell either of two stocks you hold. Both are currently worth $10,000. Which stock would you sell?
A This stock holds a 20% unrealized gain.
B This stock holds a 20% unrealized loss.
Selling stock A validates your good decision to purchase it in the first place. It would make you proud to lock in your profit. Selling stock B at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. Most individual investors would sell stock A, as it triggers the feeling of pride and allows one to avoid regret. You see, it is a human trait to avoid actions that cause regret and seek actions that evoke a sense of pride. Investors often regret the actions they take, but rarely regret the ones they do not.
So, why is it a problem that investors sell their winners more frequently than their losers? A study done years ago looked at 10,000 different trading accounts at a national discount brokerage during a 6-year period. The research showed that the winning stocks that investors sold out-performed the losing stocks that investors kept by more than 120% during the following 12 months. (Interestingly, investors in this same study held losers for twice as long as winners!) In general, out-performing stocks continue to outperform, while under-performing stocks continue to underperform.
Besides the fact that we can sometimes be predisposed to selling winners too early and riding losers too long, another important reason relates to U.S. tax law. The taxation of capital gains makes the selling of losers to be a true wealth-maximizing strategy. Selling a winner leads to the realization of a capital gain and hence payment of taxes. Those taxes reduce one’s profits. On the other hand, selling losers allows one the chance to reduce taxes, thus decreasing the amount of the loss.
Now let’s reconsider the question above and assume that capital gains are taxed at just a 15% rate. If your positions in stocks A and B are each currently valued at $10,000, the original purchase price of stock A must have been $8330, and the purchase price of stock B must have been $12,500. If you sell stock A, you receive $10,000, but pay taxes of $265.50, so your net proceeds are $9,734.50. Alternatively, if you sell stock B and receive $10,000 plus gain a tax credit of $375 to be used against other capital gains, your net proceeds are $10,375. If your tax rate is higher than 15% (which is most likely the case if you hold the position less 12 months), the advantage of selling the loser is even greater. However, most investors would rather sell the winner even though selling the loser is the wealth-maximizing strategy.
Whether or not you have ever exhibited the behavior detailed above, it is simple to see how a structured, risk-controlled system can help investors to make better decisions with their money. Often, even seasoned investors let their emotions cloud their sound judgment, and end up making the wrong decision; which can be very costly. The key to investing is removing emotions from the equation and avoid the behavior detailed above, and the key to growing any portfolio is simply to ride the winners and cut your losses while they are still small.
GorillaTrades takes the guesswork out of investing by telling you which stocks have the highest potential for capital appreciation, and then clearly explains when to enter into a position, and when to exit. With the Gorilla’s market advice, you can easily navigate through this “jungle” of a stock market as the Gorilla simplifies investing by identifying and holding the winners, and quickly cutting the losers. Join GorillaTrades today!