The stock market tends to go down in late December. Why? The January Effect suggests that large funds tend to rebalance their portfolios and investors sell underperforming stocks to take advantage of capital losses at the end of December.
This may affect your stocks—even if you don't sell anything. This may also be a tactic you can take advantage of.
Selling Stocks to Take Capital Losses
When calculating the annual rate of return you want to achieve, you must account for taxes. Unless you're investing in a tax-deferred mechanism such as a 401(k) or a post-tax mechanism like a Roth IRA, you'll pay either a short- or long-term capital gains tax when you sell stocks.
At least, you have to pay taxes when you make a profit, and that profit is for the entire tax year. That tax isn't paid for each transaction; it covers the year as a whole, allowing you to offset profits by selling stocks for a loss. The basic principle is simple: any losses will offset any gains. In other words, you pay taxes on the net capital gains from stock sales. Net capital gains is the sum profit of all stock sales minus the sum loss of all stock sales. If you made $1000 selling McDonald's stock and lost $800 selling Xerox stock, your net capital gains would be $1000 - $800 or $200.
This isn't trivial; you have to understand the difference between short-term and long-term capital gains. Selling stocks at a loss may be beneficial in some circumstances, but the details depend on your own situation. Consult a tax professional for specific advice.
What is the Wash Sale Rule?
Suppose you've found an undervalued stock. You bought it. It then started to lose money (and you think that trend will continue). It's still a good company and undervalued, but for the foreseeable future (this tax year), its price isn't going up.
Can you sell your shares, take the loss, and claim it on your taxes?
Potentially, depending on the SEC's Wash Sale rule. If you buy more of the same stock within 30 days of a sale, you cannot apply the losses when calculating your net capital gains or losses. The details sound complicated, but remember this: buying and selling stock within 30 days has tremendous implications for your tax position.
Remember, though: the goal of value investing isn't to minimize capital gains taxes. It's to build wealth over the long term. Managing your taxes is part of that, but it's far more important to buy great stocks at good prices and let the market pay you back.
What is Portfolio Rebalancing?
If taxes aren't a concern—especially if you're investing in a non-taxable or not-yet-taxable fashion—does it make sense to rebalance your portfolio at the end of the year?
Portfolio rebalancing is a way to reduce your risk by diversifying your investments. In its most naïve form, you sell your higher performing stocks and buy more lower performers.
Think about that for a second. Does it make any sense? Get rid of the winners and buy more losers? A better approach is to reduce the amount of your portfolio you have in risky investments and increase the amount you have in safer investments. It's almost a cliché: put more in index funds or bonds as you get older.
The time of year when you do this is arbitrary. It doesn't have to be December. Arguably December is a poor time to do this, as the market's frothy from people churning stocks for tax purposes. You can just as easily reinvest dividends from riskier stocks in safer places—no selling required. Of course, if you have the bulk of your portfolio in a good index fund which tracks the S&P 500, rebalancing is rarely an issue.
Can You Predict December Selloffs?
If there's a trend of stock selloffs in December, can you profit from it? That also depends. Are your target stocks going on sale? The January Effect is real enough to have a name and serious analysis behind it, but can you predict a drop in the DJIA in general or a specific price reduction for the right stock you want to buy?
This is a specific case of the general question of whether value investors should time the market. If you're not pursuing specific tax benefits and if you're not watching specific companies for bargains, there's little point in trying to buy or sell in December. Remember, the only way to make money in the stock market reliably is to buy good companies low, hold them, and sell high. If you can't find good stocks at good prices, you're better off waiting (keep your money in a low-cost index fund).
Timing the market means predicting the actions of millions of investors is difficult. If you have your goals, research, and plan, stick with it! Don't let the desire to make a few quick bucks in the short term distract you from your real goal: building long-term wealth in the stock market. Decembers come and Decembers go. Healthy businesses make money annually, consistently, over time—they're the stocks you want to own for decades.
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