Although we strongly recommend a simple buy and hold strategy of several diversified ETFs in a portfolio, we all made the mistake of individually picking a few stocks. Some have been more successful than others. Likely, you might still hold a couple of loss-making stocks. Understanding when you should sell them is critical to maximize their net value, and reduce your taxes, although they are not worth much.
Why investors might choose to hold loss-making assets in their portfolio
No exit strategy when entered in the position
This is a very common mistake. We usually buy a stock because we believe that it will grow over time, without considering that it may go down. Successful investors think about the exit of the position before they even enter in a position. Indeed, if there is no clear exit, it might not be worth to get in. Thus, we missed to put a stop loss order or were not sure when would be the time to exit the position.
Although, we should have closed the position earlier, we didn’t want to bank the loss. We were hoping that the stock would recover at some point. Regrettably, the stock value remains very low and doesn’t seem that it will ever recover. Now that we are stuck with some bad performing assets, what should we do?
Potential for future growth
Loss-making assets may have a lot of potential for growth in the future, and investors may believe that they will become profitable over time. Although the drop was significant, we still hope that it will recover. But when it entered the -50% territory, it is unlikely to recover to your entry point in a near future. Why? Because it would need to increase by 100% just for you to breakeven.
Diversification
Holding a mix of assets, including those that are losing money, can help to reduce overall portfolio risk by spreading out investments across different types of assets. This can actually be a reason, but I hope that your portfolio has other assets providing the diversification.
Emotional attachment
Some investors may hold on to loss-making assets for emotional reasons, such as a strong personal connection to a particular company or industry. It is perfectly acceptable if the person is aware of this affection, and doesn’t expect any financial value from the investment.
Tax benefits
Loss-making assets can be used to offset gains in other parts of the portfolio, reducing the overall tax bill.
How to reduce your Taxes with loss-making assets?
Capital Gain tax
Capital gain tax is very common in most countries. It ranges from 0% in Hong Kong or Singapore, to around 20-26% in Spain, to 30% in France, all the way up to 42% in Denmark. Ouch!
The only interesting part of capital gain is the capability to offset gains with losses. If you gain $10,000 on stock A, but accumulated loss in the amount of $8,000, your capital gain tax is now based on $2,000.
Value of loss-making assets
We are always unhappy to hold loss-making assets. Their intrinsic value has significantly dropped, and might not worth much anymore. However, the underperforming assets have a great extrinsic value through their capital loss potential. This capital loss can even be more important than the asset’s value.
Let’s run a simulation. We bought some shares with an acquisition price of $1,000. Sometime later, the stock value has declined by 20%, 30%, all the way down to 95%. For each of these scenarios, I will look into the tax reduction when we use the capital loss to offset a capital gain. For this exercise, I simulated a range of capital gain tax rate at 10%, 20%, 30% and 40%. The Net Value takes into account the current market value and the tax reduction. Finally, I compute the tax reduction contribution to the Net Value.
Around a drop of 80% of the value of the stock, the tax reduction starts to account for as much as the current value of the stock. Even if your stock ends worthless in the market, it will still value a tax reduction in the amount of the total value loss x Capital gain tax rate.
If might sound extreme, but I do hold 2 stocks which performance are respectively -56% and -99%. Their combined weight in my portfolio account for 0.15%. I would have gladly sold them a long time ago to simplify our portfolio. However, I keep them, and use their capital loss potential to offset any capital gain that I have.
Tax Loss harvesting
Tax loss harvesting consists of selling underperforming and losing money assets, and use their capital loss to reduce the capital gains generated from other investments. It is a common practice by investors that you should put into practice. There is no limit (in most countries) on the amount of capital loss than you can use to offset your capital gains. However, you will not get a tax credit if you have more capital loss than capital gains (except in some countries).
Personally, I prefer to keep loss making investments in my portfolio until I need to sell them to reduce my taxes. In fact, towards the end of a fiscal year, I compute the amount of capital gains that I have accumulated during the year. If I have some loss-making assets, I would likely sell these to offset the gains, and reduce my tax liability. But I would only sell the amount needed to offset the gains, not more.
Many countries allow to carry forward your capital loss in the future. In France, you have 10 years to use up your capital loss, but you have only 4 years in Spain. As we move every couple of years, we rather keep our potential capital loss in our portfolio, and use it when needed. It is a better option than leaving credits of capital loss in different countries, which will evaporate over time.
Finally, each country has its tax specificities, and you should DYOR for your own situation or seek the professional assistance of an accountant or a lawyer.
Do you also have some loss-making assets? Have you sold them a long time ago? Or are you still holding them and for what reason? Please share your feedback and Happy tax loss harvesting!