Don't Throw Good Money After Bad; When To Sell A Losing Investment

Editor’s note: This post originally ran in October, but with the recent stock market dips lots of readers have been asking whether they should sell losing stocks.

Let this post be your guide. Sell a stock if a). it no longer match your investing goals — or you bought it for the wrong reasons to begin with, b). as part of reallocations or tax-loss harvesting in your portfolio, or c). you need the cash.

Do NOT sell a stock just because the price is down. Buying high and selling low is not how you make money in the stock market! -David.

It’s every investor’s nightmare: that stock you bought sinks lower everyday.

If it sinks 5%, you tell yourself the market is fickle. It’s down 10% and you start to worry a little, but continue to believe it will rebound. How do you feel after a 20% drop? 50%? Panic can set in quickly.

Successful investing hinges as much — if not more — on knowing when to sell as it does on knowing when to buy.

Problem is, knowing when you should sell a losing investment is far harder than it sounds.

Part of the reason is a breakdown a logical fallacy around breaking even. If you lose 10% on an investment, how much do you need to gain back to break even?

Without thinking about it, you might answer 10%. In reality, a stock that loses 10% of its value needs to gain 11% in order for you to break even. At a 20% loss, you’ll need to gain back 25%. And if you’ve lost half, you’ll need the stock to double just to get back to even.

Here’s what that looks like:

So how can you know when to hold on and when to just cut your losses? To get a reliable answer, you’ll need to ask yourself some questions first:

Why Did You Buy The Investment?

The first thing you need to address is the reason why you bought the investment in the first place.

If you bought a stock because of its balance sheet and it starts taking on a lot of debt, then the circumstances in which you bought the stock have changed. It may not make sense to continue holding on to it. However, if the stock dropped due to an event like lower than expected job creation figures, then it’s a safe bet that the whole market is being brought down and has nothing to do with the underlying fundamentals of the company you’ve invested in.

If, on the other hand, you bought the stock because of a “hot tip” or other pure speculation about an unknown company’s chance to skyrocket, you probably shouldn’t have bought the stock in the first places. Although there are lots of reasons the stock could be declining, it could very well be that it was overhyped in the first place.

Is Your Portfolio Off-Balance?

As you grow older, certain investments may not make sense in your portfolio anymore. For example, if you own a speculative stock or an emerging market fund in your 20s or 30s, that might make sense. But if you own it less than 10 years before you retire, you should think about selling or at the very least, cutting back your position in those riskier investments. You should check your allocations once a year and make sure everything is still aligned with your risk tolerance.

Do You Need the Cash?

Life happens. You might be buying a house, changing jobs, or having children, and you might need cash to make it happen. Or you may have already dipped into your savings and need to replenish them. (It’s important to stay diversified and hold at least a few months’ worth of savings in a liquid account).

In these cases you may need to sell some investments and it may make sense to shed some underperformers.

Can a Capital Loss Help Your Taxes?

Sometimes selling an investment at a loss for tax reasons (called tax-loss harvesting) can actually help you save money.

If you are investing in a taxable account (not an IRA), the tax code allows you to use capital losses to offset your income up to a maximum of $3,000 every year. And if your losses exceed $3,000, you are allowed to carry forward  losses in excess $3,000 to offset gains in future tax years. For example, if you had long-term capital gains of $5,000 and a short-term capital loss of $2,000, you could take the loss and be liable only for the net $3,000 gain.

If you are considering selling stocks for tax reasons, always consult with a CPA to ensure you understand your individual tax consequences.

Other Considerations

Taking a loss is always painful, but it can be an education of sorts.

Smart investors will set a price target for selling a stock before they even buy it. With a price target, you have some kind of benchmark to measure gains and losses against to get a better idea of what range of volatility is expected, and what means trouble.

As always, the best defense against loss is proper diversification. If you took the appropriate risk and determined that you could stand to lose 5% of your total portfolio in one company and it drops 50%, your portfolio as a whole will only be down 2.5%. Mitigating these percentages can make a losing stock irrelevant to the long term goal of retirement.

What about you? When do you decide to sell an investment?