Should you sell your stocks?

Posted Aug 16th 2007 12:22PM by Peter Cohan
Filed under: Define Investing, Personal Finance

If you need the money you've invested in stocks within the next five years, you should consider selling your stocks and parking the proceeds in a money market fund that invests solely in U.S. Treasury instruments. If you can wait for that money for more than five years, you will need a strong stomach as the markets correct. But eventually, markets will recover.

To decide whether you should sell your stocks now, you need the following information:

The price at which you bought the stock(s)
The current market value
The tax rate you'll pay if there's a capital gain
An assumption about how far down your stocks will go in the next five years
An estimate of the after tax rate of return you can earn in a money market fund

If you have this information, you can do a quick calculation of whether you should sell now or hold on for the painful ride. Here's an example:

Let's assume you own $50,000 worth of stock in an S&P 500 index fund -- as it was valued this morning -- and that you purchased these shares in 2005 for $40,000. This implies that if you sold, you would pay a long-term capital gain at a tax rate of, say, 15%. We could assume, pessimistically, that the S&P 500 will decline 20% over the next five years and that if you took your capital gain now, you could invest the money at 3% in a double tax free municipal bond fund.

With this set of assumptions, let's compare where you would end up in five years under two options:

Sell now and reinvest in a money market fund: 5% compound annual return after seven years (e.g., if you invested $40,000 in 2005 and took the proceeds from selling now after tax -- $48,500 (=$50,000 - the $1,500 capital gains tax payment) -- and invested them for the next five years at 3% -- you would end up with $56,225.
Keep the money where it is: 0% return after seven years (e.g., the $40,000 you invested in 2005 is worth $40,000 at the end of 2012 since it declined 20% from the current $50,000).

The conclusion from this analysis would be to sell now and reinvest in a money market fund.

Some caveats: If you use different assumptions, you will get different answers. The example vastly oversimplifies the financial position of most investors. And it would make sense to analyze this decision under different scenarios -- e.g., pessimistic, optimistic, and status quo -- since it is impossible to predict the future.

However, with the markets in free fall, it does not make sense to just sit there and do nothing. It might be good to start thinking along these lines about whether it's best to hold on and wait out the decline or sell and reinvest in something safer.

Unfortunately, as I posted earlier, what looked safe before might not be safe anymore.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.

Tags: featured

Print this

Reader Comments (Page 1 of 1)

8-16-2007 @ 12:57PM

R.Abrams said...

I am so angry at people who speak of the capital gains tax as "only" 15%...I live in NYC, and if you add the state and city tax, it comes to almost 28%.
Don't other states have somewhat similar taxes?

8-16-2007 @ 3:08PM

Jerry Bluhm said...

Peter, I enjoy reading your post, but as usual I disagree with you. The correction we are in will not last five years for one thing for several reasons. Also, we will come out of this credit crisis within a fairly short period. Most Americans are working and most are spending. The fact they have been spending so much of their income on energy will chance soon and when it does we will see the inflation stabalize and retailer possibly cut prices. By the end of the next quarter sharp increases in retail sales will have occurred and once again the consumer will fuel the economy. These are times not to sell, but buy carefully. Lots of money to be made here, and I am a buyer for the first time in a long time.

8-17-2007 @ 4:24PM

bobsadviceforstocks said...

Peter,

Many of the considerations that you have written about are important for investors to consider, but I have found that it is necessary in the course of managing my own personal portfolio (that I write about on my blog Stock Picks Bob's Advice) to consider each of my holdings independently of tax considerations, my guess about future stock price moves, or money market returns.

Simply put, I have found it wiser to simply limit my losses and by selling my appreciating stocks partially to maximize my gains. The rest of the analysis interferes with the most important and fundamental issues confronting the individual investor, which is when to sell your stock on the downside or the upside.

Thank you for your thoughts as well. I just think like can be simpler.

Bob