Tax Loss Selling or Dealing With Your Mistakes

Canadian MoneySaver

Benj Gallander

There is only one reason for tax loss selling — errors were made when buying. And the fact is, that anyone who hangs around stock markets long enough will make mistakes. The only thing is, some people wonit admit them!

A story I enjoy is about a person from Hong Kong who read my most recent book, The Uncommon Investor, and gave it one of its few negative critiques. He wrote, “Meanwhile, the portfolio constantly alluded to in the book (the Contra the Heard portfolio) contains stocks that performed abominably (a stock that went from US$2.26 to $0.13, another that went from US$31.17 to US$10.25), in addition to their winners.” He missed the point. It is by recounting the history of the losers that one can hopefully identify where mistakes were made and avoid them in the future. And, as for those disappointing dogs, one tries to choose an opportune moment to sell them to minimize the toll.

The key question is: When you have washouts, what is the best thing to do with them? Wait and hope they will turn into winners, or, give them the boot? If the latter strategy is chosen, then the more pertinent question is: When is the best time to dump these duds?

Letis start with the first option. Simply waiting and hoping that a stock will turn into a winner makes a good deal more sense when one does not have capital gains to write the failure off against. This is critical. If gains do not exist, then the stock should be reassessed to determine if its fundamentals warrant it worth holding.

Now for the second question: When is the best time to dump? A key consideration when analyzing the sale of a loser is whether or not you want to buy it back. In our case, we only buy stocks that have been badly beaten up. This means that we make the majority of our purchases in December, towards the end of tax loss selling season, when people are dumping their losers. By following this methodology, an additional one to three
 percent can be made on most transactions. In some cases, even a bit more.

Now, letis say that a loser in the portfolio is a stock that we still want to possess. If there are gains to be offset, our choice is to sell the company, and then to repurchase it. The sale, therefore, must be done at least 30 days ahead of buying it back to qualify with Revenue Canada as a capital loss. Therefore, at Contra, we will target selling the stock in mid-November at the latest, so that a buyback after mid-December can occur. Of course, this maneuver does entail the risk that the stock will slip away during the 30-day “cooling off” period. If it does, we donit chase it and simply say, “Sayonara” and look for another deal that meets our criteria.

Something like this happened last year with Fleming, which was sold in November. But when the Christmas season rolled around, we still did not repurchase the stock, feeling that there was still some downside left. In this case, we were rewarded and bought the stock back for a few dollars less in February of this year.

Normally though, it is preferable not to wait until mid-November to sell. Disposing of losers can be considered as early as June and by mid-September we hope that they are out of the Contra corral. Sometimes though, this “schedule” is allowed to slip, as our belief is that the stock will retrace some of the decline before year-end.

Trying to time the sale during such a short time frame is a very inexact science. One method to use is checking to see if the company has an element of seasonality to its stock price. For example, it might be noticeable that the company has faded in the fall during eight of the past ten years. In this case, it would make sense to dump the firm during the summer. Or the contrary might be true, where the stock price generally increases towards the end of the year. Under these circumstances, it pays to gamble by waiting until near the end of the year before dumping. Again, this is a market timing guessing game that is preferable not to have to play, but becomes a necessity when losers are in the portfolio.

This situation becomes more complex when an individualis tax bracket is thrown in. People in the top tax range will receive the maximum “losers” benefit when they sell the stock. For those in lower brackets, they should be considering whether they will be in a higher category in the next year or two, so that the loss might lower the amount of taxes they have to pay by an even greater amount.

It is our experience that it is usually worthwhile to admit failure, take our licking, and dump our non-successes. In certain cases, we choose to hold on, when it appears that the stock is ripe for a move. We did this last year with a few of our stocks that were so badly beaten down, that the upside appeared irrepressible.

How has it worked out? Well, for one thing, they proved to be exceptionally volatile. Denison is up a remarkable 78%, while at the other end of the scale NovaCare ditched half of its value. Overall, we are ahead on these six stocks, but the alternative of simply ejecting the lot last fall and then buying back selectively gives food for thought. Would we have repurchased the right ones? We like to think so, but then it is always easier to be smarter in retrospect!

Published September 1999,
Canadian MoneySaver