Envision The Decision To Sell Stocks: Financial Advisors' Daily Digest

by: SA For FAs

Summary

Jeff Miller: How to think about whether to take profits and pay taxes.

Roger Nusbaum offers approaches to “alternative retirements” for those who may be underfunded.

Yuval Taylor: Why low beta outperforms.

Legally avoiding taxes is a vital part of sound financial management. While tax rates vary with your jurisdiction, the odds are high that your combined federal, state and local tax payments add up over time to one of the biggest expenses of your life.

That is why those saving for big lifecycle goals such as retirement or college do so in tax-favored accounts. And even among different qualified accounts, there is tax arbitrage to be had. For example, many retirement savers with traditional IRAs re-characterize to Roth accounts, paying more in taxes now in low tax-bracket years to get tax-free growth in later years.

All of this is so understood, so ingrained, that it strengthens an instinct to avoid paying the tax man under any circumstances, even when good financial management suggests you should take the tax hit. And therein lies the value of Jeff Miller's new article on SA discussing how to think about whether to take profits and pay taxes.

For those who have maxed-out their tax-qualified accounts and manage money in a taxable account, Jeff's article helps you quantify - and visualize (important for those who don't like quantifying!) - the cost you pay for adhering to your instincts to not pay taxes. He displays a tax tool that helps an investor make the difficult decision whether to take a known tax hit versus the unknown of holding stock with the hope of further appreciation (and a lower tax rate if short-term capital gains can be avoided).

This matter can never be completely certain because one side of the comparison involves uncertain future stock gains or losses.

But since instincts may bias an investor toward holding and the investor will have to pay taxes anyway - possibly on a smaller gain if holding the stock turned out to be counterproductive - it is worth thinking this through. Jeff helps frame and quantify this matter.

For my part, I would simply add a little psychological support for the idea of selling stocks under certain scenarios. First, I view investing as a long-term affair, and don't recommend non-expert investors trade in and out of stocks. But I do recommend that investors re-balance their portfolios to the target that meets their objectives. I've known too many investors, including those very close to retirement, whose stock-heavy portfolios have rocketed forward over the past decade and they can't get off the train for fear of missing out.

That means they're risking going into retirement without sufficient financial cushion. This is unwise. If the average bear market lasts a year and a half, and if we want to be conservative and consider the possibility that the next bear market will be above-average (meaning longer-lasting) just as the current bull market has been, then the smart thing to do would be to ensure you have enough cash for at least two years. That way you can sail through the next bear market without having to sell any stock; what's more, you get to sell shares when they're worth something (i.e., now) and resume sales only when the market has recovered to pre-bear-market levels.

Just as Jeff's tool helps investors envision the decision to take profits or not, I'd like to offer my own modest contribution to this visualization. Let's say you sell a stock and it turns out to be near its peak price. This is the stuff people crow about. And let's say you don't and the stock falls to a loss or to a reduced profit. This you won't feel much like crowing about. To help you internalize this feeling prior to making a decision, go out and buy a lottery ticket. When people lose the lottery they tend to rip up the ticket and throw it away. This time keep it, or even frame it, as a reminder of what could have been with that dollar - a donation to charity, a chocolate bar for your kid, etc. Don't be sentimental about your winning stocks when there is a reason to sell, such as the benefit of maintaining the proper level of portfolio risk.

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