When to Sell Stocks at a Loss

Markets remain heavily volatile and firmly in the red in June 2022. The equity and bond market sell-off that began in January persists amid decidedly stubborn inflation and higher-than-expected interest rate hikes.

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The latest consumer price index report from June 10 showed U.S. inflation figures at an 8.6% year over year increase for May, surpassing consensus expectations. As a result, Federal Reserve Chairman Jerome Powell raised the federal funds rate by 75 basis points shortly thereafter, the biggest such move in 28 years and a stark contrast to previous statements favoring a series of 50-basis-point increases.

These macroeconomic events precipitated another sharp sell-off, with the S&P 500 and Nasdaq both falling into bear market territory, defined as a drop of 20% or more from recent highs. Investors holding stocks that outperformed during the COVID-19 pandemic, such as Netflix Inc. (ticker: NFLX) and Meta Platforms Inc. (META), are likely nursing heavy losses.

While the Reddit and TikTok retail investing crowd might chant “buy the dip” and loudly attest to their “diamond hands” — a term referring to investors who opt not to sell in the face of losses or market downturns — the decision on whether to sell at a loss is more complex than blindly bag-holding through all market conditions.

A variety of behavioral and tax-related factors can influence an investor’s decision on whether to lock in a capital loss. That is to say, sometimes selling stocks at a loss makes sense, and other times it does not. Here are some expert tips on when to sell stocks at a loss:

— Don’t succumb to emotions or make rash decisions.

— Assess whether the fundamentals have changed.

— Look for tax-loss harvesting opportunities.

Don’t Succumb to Emotions or Make Rash Decisions

It’s easy to get heated and carried away when your portfolio is hemorrhaging money daily. However, keeping irrational emotions under control is key. Investors facing heavy losses have to walk a tightrope between “catching a falling knife” and panic-selling.

The former refers to the tendency for people to double down on a losing proposition because of the effort, time or money invested, despite current and future costs outweighing expected benefits. Panic-selling refers to people’s tendency to favor loss aversion, which prompts many to overreact and take drastic action to avoid further losses instead of rationally analyzing the situation.

Charles Qi, CEO of StockPick.app, believes that the best way to mitigate those behavioral biases is by creating a “safety buffer” in advance. “Investors should examine their portfolios to determine if their equity exposures are appropriate for their current financial situations,” he says. According to Qi, the best way to not panic-sell or catch a falling knife is to preemptively size your risk tolerance accordingly and not purchase stocks or risky assets beyond that level. When losses manifest, taking a step back and objectively assessing the situation based on your investment plan is key.

Ted Wozniak, head of U.S. asset management distribution at SEI Investments Co., agrees: “An investor’s investment strategy should be predicated on their time horizon and risk tolerance. Understanding specific needs and circumstances can really shape decisions around selling or holding individual stocks.” He suggests using a market correction to reassess your investment plan to see if it still holds up in tough times and whether you can stick to it now and in the future.

Overall, investors should try to let go of their emotional connection to a stock pick. Doug Amis, president and CEO of Cardinal Retirement Planning, suggests asking yourself: “Would I still buy the stock today at this price?,” as a rule of thumb for deciding whether to sell. “Think about the present and future, while discounting past performance,” Amis says. This approach may help investors consider the objective factors behind their stock picks in a more rational manner.

Assess Whether the Fundamentals Have Changed

With this in mind, investors should avoid panic-selling solid stocks and catching a falling knife with those that aren’t as sound. A good reason to sell a stock at a loss is if the underlying fundamentals behind the company have significantly deteriorated.

History is filled with once-great leading companies, considered the bluest of blue-chip stocks, falling from grace after their management, revenues, margins, earnings or strategies took a turn for the worse. “There are many examples of this in the last 20 years such as Blackberry and Intel,” says Josh Simpson, vice president of operations at Lake Advisory Group. “Investors should stay up to date with their stock picks and not blindly trust in the staying power of blue-chip, large-cap companies,” he says.

Simpson further advises that investors pay close attention to a company’s forward guidance, especially in terms of dividends. “Anytime you read that a company is cutting their dividend or discontinuing their dividend, that is a sign that things are not going well,” he says. Robert Johnson, professor of finance at Creighton University’s Heider College of Business, agrees: “Companies are loathe to ever cut dividends, as that sends a very negative signal to market participants. When a company cuts a dividend that is a strong signal to the market that the firm is experiencing financial difficulties, like with General Electric Co. (GE) in 2017.”

Johnson also recommends that investors pay attention to their fundamental case for owning a stock and assess if the intrinsic value of the company has markedly shifted due to negative changes in strategy, competition or management. “For instance, a drug company could have an unsuccessful trial for a widely anticipated drug, resulting in a downward revision of future revenue and earnings,” Johnson says. This would be an appropriate trigger to sell as the thesis for owning that stock has changed and the future outlook is no longer positive.

Look for Tax-Loss Harvesting Opportunities

If your stocks are held in a taxable account, a good tactic might be tax-loss harvesting. To recap, when investors sell a stock for a profit, they must pay federal capital gains tax, which has two rates: long-term if you held the stock for at least a year and a day (0%, 15% or 20% based on your tax bracket) and short-term if you held the stock for any time period less than that. Short-term capital gains are taxed at one’s ordinary income tax rate, up to 37%.

The opposite is also true. If you sell a stock for a capital loss, you can claim a tax credit to offset future gains. There are some rules around this though. Firstly, the IRS requires that gains be offset by the corresponding type of loss. That is, short-term losses can only be applied to short-term gains, and long-term losses to long-term gains.

Brett Bernstein, CEO & co-founder of XML Financial Group, also cautions investors to be aware of the so-called wash-sale rule. “When you sell a security at a loss, you cannot repurchase or purchase one that is substantially identical to replace it within 30 days before the sale and 30 days after it’s complete,” he says. This can be disadvantageous to investors who have to sit on the sidelines in cash and miss a potential rebound.

To get around the wash-sale rule and the IRS’ definition of a “substantially identical” security, Ann Guntli, partner and portfolio manager at RMB Capital, recommends “buying a placeholder security.” For stocks, this could mean a competitor in the same industry or sector with a high correlation. An example might be substituting Advanced Micro Devices Inc. (AMD) for Nvidia Corp. (NVDA), or Visa Inc. (V) for Mastercard Inc. (MA).

Keep in mind that the above examples are hypothetical. To determine whether two exchange-traded funds qualify as “substantially identical,” and whether or not a transaction violates the wash-sale rule, investors should consult a financial planner, tax attorney or accountant.

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When to Sell Stocks at a Loss originally appeared on usnews.com

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