Is realizing short-term stock gains beneficial?

Personal finance, Value investing

A friend and I were talking the other day about how different our approaches were to the stock market. After having read Benjamin Graham’s classic *, I decided to try and be disciplined about choosing and buying stocks as well as keep a long term perspective. My friend argued that, using his own methodology, his stock picks had sometimes already realized 20-30% gains in a few months’ time, and so they were worth selling in order to reap these gains before the stock went down again, even if he had held his picks for less than a year. This seemed to make some sense too. After all, if the market shot to 12,000 tomorrow, wouldn’t most people assume it would be unsustainable and drop? In that case, wouldn’t it make sense to sell and rebuy at a lower price?

hypothetical stock performance
As most of us have read, heard, or been taught, frequent trading increases transaction costs such as taxes and commissions which then eat up would-be gains. So I decided to work out some of what was going on behind this reasoning, and perhaps find a breakeven point where realizing enough short-term gains would outweigh tax implications.The graph above is an illustration of the example I worked with. Suppose you originally purchased a stock at a price of P1. It went up, and at some point, you thought the stock would drop before continuing on its merry way upward. How would you figure out whether it was worth selling (at a price of S1), and then rebuying after it had dropped (to a price of P2), with a goal of selling when it had reached a high of S2? (Sorry about the 1’s and 2’s — it was just easier to work out the algebra this way.)

As it turns out, the breakeven point where the impact of short-term capital gains tax would be less than the amount you’d gain from selling depends on many things, one of which is your income tax bracket (%), because in general, short-term capital gains are taxed at this rate. For this calculation, I assumed that long-term capital gains (e.g. holdings of greater than 12 months) would incur a tax of 15%. I also ignored commisions and state taxes for simplicity, though these could be added in easily. I’ll spare you the details, but the formula below shows the impact of short-term capital gain tax rates on your gains.

(S2-P1) < Factor x (S1-P2)

Essentially, the impact of the tax rates is encapsulated in the “Factor” described above. The table below shows how to calculate whether it’s worth selling or holding on to your stock given your income tax bracket.

For example, let’s say your tax bracket is 28%. Then, in order for it to be beneficial to sell a stock that you’ve held for less than a year at a gain, the difference between the ultimate sale price (S2) and the original purchase price (P1) must be less than 5.54 times the difference between your intermediate sell price (S1) and your subsequent purchase price (P2). The 5.54 multiplier in this case is the “factor” in the equation above for a person in the 28% income tax bracket. In other words, this person would use the following equation to figure out if or when it would be worth selling for a short-term gain:

(S2-P1) < 5.54 x (S1-P2)

As the table illustrates, the higher your tax bracket, the less likely it is that selling short-term would be worth doing, because you would be paying quite a bit more in taxes than at the 15% long-term capital gains tax rate. Similarly (but perhaps not as obvious), the greater the difference betwen the initial purchase price and ultimate sale price (the left hand side of the formula above), the more unlikely it is that a short-term sale would be beneficial, because the less likely it is to satisfy the “less than” condition. Also, and I’d have to think about this a little further, but it would seem that the less volatile a stock price’s movements, the less likely a short-term sale would be beneficial as well, for similar reasons.
Short-term capital gains factor table

For anyone who’s read this far, you can see that therein lies the crux of the issue: how sure are you of the future? It’s always easy to look back with 20/20 hindsight, saying “had I sold then” or “had I bought then”, but let’s be realistic. At the point where you’d be making the decision, the stock has presumable already had a good, if not surprising, upward run. Would you have had the discipline to then think, “I’ll sell now to reap in gains,” at the risk of selling too early, or would you wait for it to fall a bit and see the momentum shift before selling? And once you did sell, at what point would you decide it was worth buying again?

Realistically, probably no individual investor would sit there and calculate breakevens and tax implications on a trade. Most would use technical analysis or “gut feel”. And most people would have trouble buying on a down day, because it’s hard to fight the feeling that the stock might continue to drop.

Finally, in order to actually use the equation above, you’d have to know at what price you’d ultimately sell the stock (S2). Can you know or even predict this?As Graham mentions in his book, no one can predict the future, so you try to control what you can, which means ensuring you have a “margin of safety” and essentially aren’t buying a stock or other investment vehicle at too high a price. Now, are there times or examples where people have made money buying and selling short-term? Certainly. And the example I’ve been using is just one of many ways in which a stock could perform. It’s just that for me, Graham’s argument makes a lot of sense and, I believe, requires expending a lot less time and energy worrying over the future than many other methods, so I’ll be sticking to it for now.

(*) Experiglot is an Amazon.com Affiliate

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Posted on 25 January 2006 by Leslie Currently, Comments and Pings are both off.

6 Feedbacks on "Is realizing short-term stock gains beneficial?"

AllThingsFinancial » Blog Archive » Day 5 - Investing in Stocks

[…] Is realizing short-term stock gains beneficial? […]

05 February 2006 at 21:08


Loi Tran

The factor is still not clear.

06 February 2006 at 0:28


Ricemutt

Thanks for the comment. I’ve added some more explanation that I hope will help clarify what I mean by “factor”. Let me know though.

06 February 2006 at 21:01


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