This Major Mental Block Could Impact Your Tax Return
Today, I’d like to wrap up our Cognitive Bias series.
Over the last two weeks, we’ve tackled your greatest enemy in the markets.
No. It’s not hedge funds.
It’s not Wall Street bankers.
It’s not some politician or central banker who can’t keep their mouth shut.
It’s your subconscious.
Benjamin Graham was the author of the finance classic The Intelligent Investor.
He was also a major influence on Warren Buffett and other value investors.
Pointing to the irrationality of investors, Graham has a classic quote. “The investor’s chief problem – even his worst enemy – is likely to be himself.“
Taming your biases is the single most important action to take as a buy-and-hold investor. Let’s look at one more bias that could impact not only your portfolio in 2021, but also your tax returns.
The “Effect” on Your Portfolio
The final boss in your cognitive bias lesson is a doozy to say…
Disposition Effect Bias
This is a fancy way of oversimplifying different investments in your mind.
We link this bias to the habit of labeling different investments as winners or losers.
We see this bias in conversation every day. Apple, for example, is widely viewed as a winner. It’s the world’s largest tech firm. It keeps going higher and higher…
But what do a lot of people do when Apple reaches all-time highs?
People sell the stock. They’re eager to capture profits.
Yet they completely ignore the fact that this is a growing company… an incredible company… and that it expects profits to rise even higher.
So, they’re selling their winners too early.
And what do people do with their losers?
Well, people don’t like to admit when they’re wrong. When their stock drops, they might ignore clear signals to sell. Instead, they’ll hold onto their losing stock in hopes that it will bounce back.
But if a stock hits negative momentum – there are many sellers and no clear indicators of a rebound – it will go lower. This produces greater losses in the process.
It ties directly to the loss aversion bias that we discussed two weeks ago. People do not like to lose money. As I noted, a person is more emotional about losing $10 than they are about winning more than $20, according to economist Daniel Kahneman.
That’s a powerful mental block to overcome. And it can impact more than just your portfolio.
The Impact on Your Taxes
I don’t spend a lot of time talking about taxes. But, I have to say, it’s very important to consider this issue when talking about your portfolio.
As you know, there are two different structures for capital gains taxes.
The first is short-term capital gains. These are the taxes that you pay on investments or trades that last less than 12 months.
Next are long-term capital gains. In the United States, the IRS classifies these investments differently. Long-term assets are those held for 12 months or more.
It doesn’t seem like too much of a difference.
But the difference between holding a stock for 11 months and 13 months can be pretty jarring at tax time.
If a married couple making a combined $250,000 sells Apple stock for a $5,000 gain after holding it for 13 months, they will pay a 15% tax on those gains. That’s $750 in taxes.
The IRS taxes short-term investment gains as ordinary income. So, if that couple sells Apple at a gain of $5,000 after 11 months, they’ll pay a different rate. Since this gain would fall in the 24% bracket, they would pay $1,200. That’s a $450 penalty for selling.
Why do I bring this up?
Because Disposition Effect Bias may drive you to quickly sell stocks that are winners. You must also consider the tax implications of selling. Not only could you be selling stocks that are poised to run higher, but you also might be giving Uncle Sam a bigger chunk than you should.
How to Avoid This Bias
There’s a solution to avoiding Disposition Effect Bias.
Stop holding onto losers. Stop selling your winners too early.
I know that sounds simple… because it is.
If you want to do the deep dive into the psychology behind this, you can. You can read the 1985 research article, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,” by Meir Statman and Hersh Shefrin.
But that might put you to sleep… and you might miss some great trades.
Instead, you can do what I do. I use TradeSmith Finance to track my portfolio, and I wait for the signals to tell me what to do. Our technology can’t make it easier.
If my stocks are in the Green Zone, even if they’ve run up 30% and I’m tempted to sell, I listen to the signal.
I’ve mentioned Apple several times. It is right there, in the Green Zone. Despite all the noise around the market and the stock, if I own shares of Apple, I can take comfort in riding this stock higher.
If my stocks are dropping and one falls into the Red Zone, I sell my losers. Even if they are the coolest company in the world.
Take Virgin Galactic (SPCE). It’s a really cool company. Yes, they might be putting wealthy tourists into space.
But this stock is in the Red Zone.
It’s very important to have rules.
They help eliminate the emotions that can wreck our portfolio.
As I conclude this series on cognitive bias, I invite you to send me a note. Do you have questions or stories about your experiences with stock market emotions? Let me know at [email protected]. I’d love to read them. I’ll even take a few, with your permission, and respond to them in TradeSmith Daily.