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 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 one of our colleagues 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!
Wowza.
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 man 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 ...
Here's an example. From March 2007 to March 2008, the top-performing Nasdaq 100 stocks were Baidu.com
A $1,000 stake in each company during that period would have earned a total of $6,757 in capital gains. That's a fantastic return.
But the gains would be less fantastic if you'd sold March 11 instead of March 12:
|
Very Crude Example |
|
|---|---|
|
Pre-tax return |
$6,757 |
|
Return with long-term capital gains tax (15%) |
$5,743 |
|
Return with short-term capital gains tax (35%) |
$4,392 |
|
Money saved in a day |
$1,351 |
Of course, delaying your sell transaction (assuming you wanted to sell these stocks) would mean you believe the stocks would trade at similar prices at a future date. The stock market's a dynamic environment, so that's far from assured.
We're hardly advocating that you wait for the mythical one-year mark to dump a stock in which you've lost faith. Not all instances would benefit you like the six stocks above.
A buy-to-hold nightmare
Let's say, for example, you were waiting for last September to sell your shares of Mongolian miner Ivanhoe Mines
In that intervening period, Ivanhoe failed to reach a development agreement with the Mongolian government ... and the stock tanked. The $300 tax savings you were expecting ended up costing you more than $1,000 in capital gains!
The Ivanhoe lesson reinforces the market's predictable unpredictability. There is no way to time the market's moves or predict its behavior accurately.
The business of investing
Although one year is an arbitrary period, the goal of differing capital gains tax rates is sound: It's meant to encourage long-term investing.
And while 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. Of course, you also shouldn't be day-trading in and out of stocks with no regard for frictional costs.
See, we know about 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 39 percentage points on average over the past six years. They have sold a number of stocks over that time, but the decision to do so was always informed by investment considerations.
If you'd like to see what David and Tom recommend today, click here to join Stock Advisor free for 30 days. There is no obligation to subscribe.
This article was first published on 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 Amazon.com are Motley Fool Stock Advisor recommendations. Baidu.com and Intuitive Surgical are Rule Breakers picks. The Motley Fool has a disclosure policy.
