Mad Money Machine

How to know when to sell a winning investment

It’s easy to know when to sell a loser from your taxable account… NOW! (Well, unless you believe it will go up significantly in the next 30 days.)

But when do you sell a winner? Harder one to answer because of the difference between short-term and long-term capital gains taxes. (Yep, the following doesn’t apply to tax-advantaged accounts such as IRAs.)

So let’s start with some assumptions. Long term cap gains are taxed at 15%. Short term cap gains are taxed at 31%. Note that these numbers probably don’t apply to you because I haven’t included state and local taxes or different income levels.

Next assumption is that our investment, 1000 shares in stock XYZ (which is presumably the Examine Your Zipper Corporation) is bought in January for $50 a share and because of the huge increase in demand for zippers in China and India (with the new style saris being zipped up I guess. Or maybe they have pockets, I dunno.), it goes to $100 per share within 7 months.

Then in August it looks like the whole market is in for a tumble as the Iranians are making noises. XYZ drops to $95.

You still believe in XYZ and think this Iranian thing will blow over. You think XYZ should be back at $100 by next January.

Do you sell at $95? How far down would XYZ have to go from $95 in order to buy it back and make the same amount as you would get by holding it until January?

First let’s look at the long-term buy and hold option:

Buy 1000 at $50
Sell 1000 at $100
Gain: $50,000
Taxes (15%): $7,500
Net Gain: $42,500

OK, so now let’s look at the short-term trading with short-term capital gains option. We need to make $42,500 just to stay even. Our stock is at $95. We sell hoping to buy it back lower. But we have to pay the additional tax.

Buy 1000 at $50
Sell 1000 at $95
Gain: $45,000
Taxes (31%): $13,950
Net Gain: $31,050

So let’s solve for a Net Gain of $42,500 and see where it has to go to buy it back…
Net Gain: $42,500 – $31,050 (our previous gain) = $11,500
Taxes (31%): to get at net gain of $11,500, we need $16,667 in gross gain. (x-11,500)/x = .31… just keep plugging numbers into a spreadsheet until you get x = $16,667

Sell 1000 at $100
Therefore,
Buy 1000 at $83

$83 from $95 means about a 14% decline from the current price in order to buy it back and recoup the additional taxes.
And that is JUST TO STAY EVEN. Ideally, you’d buy it back lower so that your effort is rewarded with more returns.

I’m searching for a more general rule-of-thumb-type answer to know when to sell a winner. If you have one, email me.

Caution: I’m not an accountant, nor a financial advisor, nor tax guru. Try these numbers and make your own assumptions. Do you have any comments about this? Email me feedback@MadMoneyMachine.com.