Don't Sell Without Reading This First

What's your biggest obstacle when it comes to making money in the stock market?

If you're like us, you want to blame the folks at the IRS. They tax our income, they tax our dividends, and they tax our capital gains up to 35%.

The effect of those taxes is enormous. As our colleague Jim Fink recently wrote:

According to the brokerage Charles Schwab, an investor who sells a stock with a short-term gain (a stock held less than 366 days) must find a new stock that outperforms the sold stock by 21.2% just to offset the taxes. In contrast, selling a stock with a long-term gain requires that a replacement stock outperform by only 8.1%. Although taxes should never be the primary driver of your investment decisions, if at all possible, hold your winning stocks for at least 366 days -- and preferably much longer!

Wowsa.

Why aren't you outraged?
It's no easy feat to find stocks that will outperform anything by 20 or more percentage points. And what's worse, because gains aren't indexed against inflation, the hit you're taking relative to your purchasing power is even larger.

For a short-term capital gain -- a stock held for less than one year -- the tax collector takes up to 35%, depending on your personal tax rate. For a long-term capital gain -- a stock held longer than one year -- the government takes between 5% and 15%, again depending on your tax bracket. Assuming the extreme in both examples, the 20-percentage-point difference is massive.

Consider ...
The top-performing S&P SmallCap 600 stocks of the past year are Lindsay (NYSE: LNN), Massey Energy (NYSE: MEE), Concur Technologies (Nasdaq: CNQR), Stone Energy (NYSE: SGY) Robbins & Myers (NYSE: RBN), Savient Pharmaceuticals (Nasdaq: SVNT), and LKQ (Nasdaq: LKQX), up 240%, 126%, 106%, 101%, 99%, 89%, and 84%, respectively.

A $5,000 stake in each company one year ago would have earned a total of $42,200 in capital gains to date -- a fantastic return.

But the gains would be somewhat less fantastic if you had sold yesterday instead of today:

Very Crude Example
Pre-tax gain	$42,200
Return with long-term capital gains tax (15%)	$35,870
Return with short-term capital gains tax (35%)	$27,430
Money saved in a day	$8,440

Of course, delaying your sell transaction (assuming that you wanted to sell these stocks) would mean you believe the stocks will trade at similar prices at a future date. The stock market is a dynamic environment, so that's far from assured.

We're hardly advocating that you wait for the mythical one-year mark to sell a stock in which you've lost faith. Not all instances will benefit you like the seven stocks above might, or like a hypothetical investor who waited until Sept. 5, 2007 -- his or her 366th day after buying -- to sell Apple. Even though the stock dropped 5.5% that day on news of the iPhone's price cut, our investor still came out ahead by taking advantage of the changing tax rate.

The business of investing
Although one year is an arbitrary time period, the goal of differing capital gains tax rates is sound: It's meant to encourage long-term investing.

And although it's tempting to get cute and take advantage of the tax code, we agree with Jim that tax considerations should never drive your investment decisions. Or as our friend and money manager Ron Muhlenkamp says, "Don't let the tax tail wag the cap-gains dog." Of course, you also shouldn't be day-trading in and out of stocks with no regard for frictional costs.

See, we believe in the power of long-term buy-to-hold investing ... as long as you've done your research up front. That means buying shares of great businesses at reasonable prices -- the kinds of businesses and prices that give you confidence to hold patiently through inevitable volatility.

Does that mean never selling? No. But it does mean that you should write down your reasons for buying a stock. Save them in an easy-to-find spot. Then, if the stock is down, refer back to those reasons to make sure they're still intact.

If they are, hold. If they're not, sell.

That's an exercise you can do whether it's Day 1, Day 100, or Day 1,000.

Do more
At our Motley Fool Stock Advisor investing service, Fool co-founders David and Tom Gardner focus on finding promising long-term prospects, keeping subscribers updated on news and valuations, and holding superior companies to beat the market over the next decade or more.

Their recommendations are beating the market by 43 percentage points on average over the past five-plus years, and although they have sold a number of stocks over that time frame, their decision to do so is always driven by investment considerations.

If you'd like to see what David and Tom are recommending today, click here to join Stock Advisor free for 30 days. There is no obligation to subscribe.

This article was originally published Sept. 25, 2007. It has been updated.

Neither Tim Hanson nor Brian Richards owns shares of any company mentioned in this article. Also, neither Tim nor Brian is brimming with righteous indignation, but it's early yet. Charles Schwab and Apple are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.