Among people who get paid to invest other people's money, Robert Loest is blazing star-bright. Gains on his IPS Millennium Fund, 119% in 1999 and 15% through March this year, recently landed him a guest spot on Louis Rukeyser's Wall Street Week. He showed a mix of high intelligence and unblinking bravado--until he got hit with this stumper: "When do you decide to sell a stock?" Loest paused a beat and confessed: "That's the hardest question."
For every investor, knowing when to sell a winner and put the money elsewhere is hugely complicated by the tax bill you can run up by trading. Except in such tax-deferred accounts as 401(k)s, Uncle Sam can chop a $10,000 gain on stock you got last fall into something under $7,000 if you're in the 31% tax bracket and sell now.
To get smarter about this, I phoned Michael Duffy, a vice-president at J.P. Morgan's Wealth Strategy Group in Palm Beach, Fla. You won't be surprised to learn that Morgan bankers follow no single rule. But Duffy made this much clear: "Every transaction that we do, we're taking taxes into account." With that as a guiding principle, I've come up with these three steps, along with a simplified example (table), to help you order your thoughts before you rush to cash in a stock or fund at a profit:
-- STEP ONE Is your current investment headed for a fall? If you're convinced that it is, then by all means sell it, pay your tax on the gain and reinvest in something better. If not, do your best to estimate the gain you expect it to deliver over the time you expect to hold it. Any forecast is chancy, but to trade intelligently, you don't have a choice. Let's say you expect 10% a year.
-- STEP TWO Ask yourself how you might reinvest the cash you get by selling your current stock or fund. How much might an alternative investment return a year? Let's say 15%. To keep this simple, I'm ignoring state taxes and dividends, which are taxed each year at ordinary income rates instead of lower capital-gains rates granted investments held more than a year.
-- STEP THREE Which will leave you richer after taxes--your current investment or the alternative? "Look at the opportunity in the stock that you are considering," Duffy suggests. "Decide whether it's going to exceed your current position, given that your capital is going to be reduced" by taxes. Suppose you bought your current stock two years ago for $20,000. Now it is worth $50,000. If you mean to keep this money invested for three more years, at 10% a year, your stock would grow to $66,550. Selling your current stock and paying a 20% capital-gains tax would leave $44,000 to reinvest. Growing at 15% annually, that becomes $66,924 in three years. That's $374 more--hardly worth the trouble. But keep going. You've got to figure how much you would have three years from now after finally cashing out and paying taxes. Hold your current stock and, after capital-gains tax, you would have $57,240. The alternative? $62,339--lots more.
In this example, selling and reinvesting works because the alternative investment's future return is 15%--half again as high as the current stock's. Plus, it compounds at the higher rate over three years. Yet if you estimated that both would gain 10% a year, selling and reinvesting would have left you poorer by nearly $1,600.
Sometimes selling is necessary to keep your portfolio diversified. Say you've hit it big with a stock like Qualcomm, now at 150, which you started buying last year as low as 15. Try a gut check: Are you comfortable with so much of your account in one stock? Chances are, the answer is no. And whenever you sell a winner, either to rebalance your portfolio or to raise cash, do what Morgan does and unload your highest-cost shares first so you pay the lowest tax.
To help you figure out the best strategy for selling, go to barker.online, where you'll find a new interactive worksheet we've developed. Let us know if it's helpful, or how to make it better.
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