Don't Sell Without Reading This First

What's your biggest obstacle when it comes to making money in the stock market?

If you're like us, you want to blame the folks at the IRS. They tax our income, they tax our dividends, and they tax our capital gains as much as 35%.

The effect of those taxes is enormous. As our colleague Jim Fink recently wrote:

According to the brokerage Charles Schwab, an investor who sells a stock with a short-term gain (a stock held less than 366 days) must find a new stock that outperforms the sold stock by 21.2% just to offset the taxes. In contrast, selling a stock with a long-term gain requires that a replacement stock outperform by only 8.1%. Although taxes should never be the primary driver of your investment decisions, if at all possible, hold your winning stocks for at least 366 days -- and preferably much longer!

Wowsa.

Why aren't you outraged?
It's no easy feat to find stocks that will outperform anything by 20 or more percentage points. And what's worse, because gains aren't indexed against inflation, the hit you're taking relative to your purchasing power is even larger.

For a short-term capital gain -- a stock held for less than one year -- the tax man takes as much as 35%, depending on your personal tax rate. For a long-term capital gain -- a stock held longer than one year -- the government takes between 5% and 15%, again, depending on your tax bracket. Assuming the extreme in both examples, the 20-percentage-point difference is massive.

Consider ...
The top-performing S&P MidCap 400 stocks of 2007 were CF Industries (NYSE: CF), Terra Industries (NYSE: TRA), Intuitive Surgical (Nasdaq: ISRG), Chipotle Mexican Grill, and AGCO (NYSE: AG), which returned 330%, 299%, 237%, 158%, and 120%, respectively.

A $5,000 stake in each company at the beginning of last year would have earned a total of $82,200 in capital by year's end. That's a fantastic return.

But the gains would be somewhat less fantastic if you sold on the last day of 2007, instead of the first day of 2008:

Of course, delaying your sell transaction (assuming that you wanted to sell these stocks) would mean you believe the stocks will trade at similar prices at a future date. The stock market's a dynamic environment, so that's far from assured.

We're hardly advocating that you wait for the mythical one-year mark to dump a stock in which you've lost faith. Not all instances will benefit you like the five stocks above.

A buy-to-hold nightmare
Let's say, for example, you bought $5,000 worth of both Microsoft (Nasdaq: MSFT) and Goldman Sachs (NYSE: GS) back in January 2007. These stocks were up 24% and 21%, respectively, through November 2007. Maybe that seemed like a sensible time to lock in gains, but let's say that you decided to wait until 2008 to avoid the stiff short-term capital gains tax.

Well, each stock has sold off substantially at the beginning of 2008 and by February, Microsoft was down 18% and Goldman 16%. The $476 of tax savings you were hoping for ended up costing you $2,106 worth of capital gains.

This scenario is a good example of the market's predictable unpredictability. There is no way to accurately time the market's moves or predict its behavior in the short term.

The business of investing
Although one year is an arbitrary time period, the goal of differing capital gains tax rates is sound: It's meant to encourage long-term investing.

And while it's tempting to get cute and take advantage of the tax code, we agree with Jim that tax considerations should never drive your investment decisions. Of course, you also shouldn't be day-trading in and out of stocks with no regard for frictional costs.

See, we believe in the power of long-term buy-to-hold investing ... as long as you've done your research up front. That means buying shares of great businesses at reasonable prices -- the kinds of businesses and prices that give you confidence to hold patiently through inevitable volatility.

Does that mean never selling? No. But it does mean that you should write down your reasons for buying a stock. Save them in an easy-to-find spot. Then, if the stock is down, refer back to those reasons to make sure they're still intact.

If they are, hold. If they're not, sell.

That's an exercise you can do whether it's Day 1, Day 100, or Day 1,000.