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Hope can be a dangerous tonic in financial markets. Namely, the existence of hope compels some market participants to hold losing investments longer than is practical.
Yes, there are instances in which dollar-cost averaging is applicable, but the old adage of “don’t frown, average down” is risky and difficult to implement when markets are tumbling. Simple math confirms as much. Buy a stock at $10 and hold it as it slides to $5 means the investor needs those shares to double just to break even.
Still, hope often burns eternal. Tangible investment results be damned. Thing is hope, which speaks to the efficacy of behavioral finance, prevents some investors from realizing there are advantages to parting with losing positions, not the least of which is avoiding further losses and freeing up that capital, albeit reduced, for better opportunities.
Beyond those two factors, there are other motivating factors when it comes to throwing in the towel on losing trade, some of which can enhance investors’ bottom lines even with the loss. Let’s explore a few year.
Tax-Loss Harvesting Is Beneficial
With Tax Day less than two months away, now is an appropriate time for advisors to discuss with clients tax-advantaged strategies, including tax-loss harvesting.
In simple terms, tax-loss harvesting is a considerable value add for clients because they likely fall into one of three groups 1) aren't aware of it in the first place 2) know about it and don't know how to implement it or 3) are wanting to hold onto a losing position and don't realize there are benefits to parting ways with that laggard.
Even better, the concept is easily conveyed to clients. Tax-loss harvesting is the act of selling a losing position to offset some of the capital gains obligations on profits on a winning trade. In an effort to make some lemonade out of lemons, advisors have ample tax-loss opportunities to consider over the near-term.
“A hypothetical investor who realized $10,000 in short-term capital gains and $15,000 in capital losses could use tax-loss harvesting to reduce their tax bill—this year and in future years,” according to Charles Schwab. “If you don't have investment gains to offset, or if you realize more losses than gains, you can use up to $3,000 in losses to reduce your ordinary income this year—and every year thereafter—until the entire loss is accounted for.”
Other Good Reasons to Ditch Losing Trades
As hard as it is for many market participants to admit they took a loss in the first place, it’ll be harder for them to admit they incurred a major loss due to emotional ties to a security or stubbornness. Beyond preventing smaller losses from turning catastrophic, there are other perks associated with parting with forgettable trades.
“There's an adage among traders: Let your winners run. If you don't want to sell your winners prematurely, it might make more sense to generate the necessary income by selling your losers—which may allow you to offset up to $3,000 a year in ordinary income in the process,” adds Schwab.
Additionally, there’s always the possibility that a disappointing trade or even a long-term investment no longer fits the investor’s objectives. For example, Jane may have taken a modest loss on a consumer cyclical stock. Now, she’s fretting about the specter of a recession that will pinch discretionary spending. It’s best to go onto greener pastures before the market effectively prices in damaging news.
“But holding on to the investment in hopes of a turnaround could erode your returns further. Taking the loss could allow you to get your portfolio back on track more quickly—and potentially offset capital gains and/or ordinary income,” concludes Schwab.
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