After huge losses in 2008 and equally impressive gains in 2009, stocks have largely taken a breather so far this year. Yet for many companies, 2010 can't end soon enough -- and unfortunately, some of them are likely to take another few lumps before the ball drops in Times Square.
'Tis the season
Every year around this time, investors go into a mini-panic. As you look at your income for the year and weigh gains, losses, and taxable investment income from your portfolio, you may start frantically looking for ways to cut the inevitable tax bill that you'll have to pay in April.
That inevitably leads to taking a hard look at your portfolio's losing stocks for the year. Harvesting tax losses is a time-honored tradition, and it can save you a ton of taxes. You're allowed to use capital losses on falling stocks, bonds, mutual funds, or other investments to offset any and all gains you've earned on sales of winners. In addition, if you have more losses than gains, you can use up to $3,000 of additional capital losses each year to cancel out regular income, including your salary or any interest and dividends you may have received during the year.
No one likes to pay taxes, so you can expect millions of your fellow investors to go through the same thought process you will in trying to find cost-cutting moves against Uncle Sam's grabby fist. Often, the wave of negative sentiment that results from tax-loss harvesting can add insult to injury by pushing the share value of losing stocks down even further to salvage what they can from investments that went wrong.
This year's candidates
Let's take a look at some of the stocks that are likely to feel the effect of tax-loss harvesting this year:
Selling $10,000 in Shares Could Generate Tax Savings of as Much as
Source: Yahoo! Finance and author's calculations. Tax savings assume 35% tax rate applies.
The reasons for these drops are as varied as the stocks themselves. In some cases, extraordinary events have caused problems. BP's disaster is well-known, and it also helped bring peers such as Total
On other cases, the causes are more pedestrian. Adobe recently guided its future earnings lower based on pessimistic projections, despite posting impressive growth. Defensive plays like utility Exelon simply haven't interested investors who got used to much stronger gains from faster-growing companies. And Medtronic is simply suffering from recession-related lack of demand for its medical equipment.
How to handle year-end doldrums
What you need to do to protect yourself depends on whether these stocks are already in your portfolio. If you own shares, then joining the mass of tax-loss sellers might be the only way you can get a benefit from the money you've lost. Unfortunately, even if you like the stocks as a long-term investment, wash sale rules force you to wait 30 days before you can buy back shares after you sell them at a loss. That leaves you vulnerable to a potential rebound, which often comes in January. So if you intend to buy back the shares you're selling for tax purposes, do it sooner rather than later.
In contrast, if you don't own these shares but are considering a purchase, you don't necessarily have to hurry to buy. Sure, a Santa Claus rally might well lift share prices across the board. But all other things being equal, selling pressure for tax-loss harvesters could give you even better bargains in the coming weeks. The low price you get may well make a great Christmas present to yourself.
Be careful out there
Events like tax-loss selling show just how inefficient the financial markets can be. By being aware of the phenomenon, though, you can turn it to your advantage.
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Fool contributor Dan Caplinger hates losing, even if he gets a tax break out of it. He doesn't own shares of the companies mentioned in this article. Exelon is a Motley Fool Inside Value recommendation. Adobe Systems is a Motley Fool Stock Advisor pick. Total is a Motley Fool Income Investor choice. Motley Fool Options has recommended a diagonal call position on Adobe Systems, writing covered calls on Exelon, and a synthetic long position on Monsanto. The Fool owns shares of Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy loves watching Dick Clark every New Year's Eve.