As the end of the year approaches, investors who own stocks that have fallen dramatically during 2012 are faced with the usual dilemma: Should they take their lumps and sell their shares at a loss, or should they hang on, hoping for a rebound? Ordinarily, the reward you get from tax-loss selling creates an extra downward push in November and December for beaten-down shares, offering an interesting buying opportunity for those who believe their long-term prospects are better than most of their peers think.
But thanks to an unusual situation this year, the tax-loss selling phenomenon may not take shape in the same way it usually does. As a result, with selling potentially deferred into 2013, you may not want to count on losing stocks bottoming out before the end of the year.
Why the usual rules don't apply
Most of the time, investors don't think much about taxes until the end of the year. Then, they make a mad rush to try to minimize their income and take advantage of any deductions they can find. One popular such deduction is taking capital losses on investments, which is also known as tax-loss harvesting.
Using this strategy, investors would sell already-crushed stocks, and as a result, opportunities would typically arise among the worst-performing stocks of the market. For instance, the tech sector has a huge divide between haves and have-nots, with successful businesses finding ways to transition toward newer technology. Yet Dell (UNKNOWN:UNKNOWN), Research In Motion (NYSE:BB), and Hewlett-Packard (NYSE:HPQ) have thus far been largely left behind by technological innovation, and their falling share prices have reflected a lack of confidence among investors that they'll be able to find their way out of their downward spirals toward recovery. Similarly, coal stocks have gotten crushed due to low natural gas prices and industrial slowdowns around the world, with Arch Coal (NASDAQOTH:ACIIQ) and Peabody Energy (NYSE:BTU) seeing especially big losses.
All of these stocks face challenges going forward. Yet because sellers want those losses, those willing to take the other side of their trades can often get amazing bargains that can pay off strongly when the selling pressure eases at the beginning of the following year.
What's different this year, though, is that many investors aren't interested in taking losses during 2012. Because higher tax rates are slated to take effect beginning in January, investors are in the unusual position of wanting to preserve losses for use in 2013 and beyond, when they'll potentially be worth more in tax savings.
Extending the downturn
One area where tax-loss selling probably won't have a big impact is among major institutional investors like mutual funds. That's because many funds are still sitting on substantial capital losses that they suffered during the 2008 bear market. Although stocks have rebounded sharply since that time, many funds have been able to offset any profits they've earned on those gains with losses they've carried forward since then.
But among individual investors, when to take losses could have a huge impact. If higher tax rates are allowed to take effect, then it could push tax-loss selling past the end of the year into January at the earliest. And if investors do what they normally do and procrastinate until the last possible moment, it could push tax-loss selling toward the end of 2013.
On the other hand, it's possible that lawmakers could break their current logjam and extend current tax breaks, either in whole or in part. If that happens, then you could see some major moves on the tax-loss selling front, presenting the more typical opportunity for bottom-fishing.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool has no positions in the stocks mentioned above. 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 Motley Fool has a disclosure policy.