Cutting loose the losing position ahead of the January Effect
December 23, 2011 at 3:20 pm by Richard Rittorno
With only four trading days left in 2011 many traders are thinking about selling their losing stocks for tax purposes — and many of them will wait for the last possible second for the hope for the off chance the position moves into the black.
But as traders sitting behind a computer screen we sometimes forget we are only one of several million people and institutions in the market. Waiting to sell on the last day of the year, traders will find themselves in competition with others attempting the exact thing.
This could result in a lower price if traders panic to sell their positions, putting increased pressure on stocks as the clock ticks down.
Researchers have done studies on what has been coined as the January Effect, which holds that stocks that decline in the year-end close to tend to outperform early in the new year. Tax loss harvesting is the reason.
Poor-performing stocks sink lower than they would otherwise throughout the year due to last-minute tax selling and then rise back in the coming year once the pressure has been eliminated.
Unfortunately, the January Effect basically creates a false “outperform” signal across traders’ screeners until the hangover wears off.
Other researchers are also questioning whether January Effect is really as powerful today as it has been in the past due to the all the changes in the markets in the past four years.
Whether the effect is still in effect — so to speak — tax selling will still occur like every year as traders and funds clean up their portfolios and look for tax losses to harvest.
Thus, it makes no sense to wait and sell in the herd. Get ahead of the herd and exit early.
Be disciplined. Traders typically hold losers longer than they should, no matter what the tax consequences.
A basic human tendency called loss aversion makes traders want to ride the out the paper loss as long as possible in the hope the stock will turn around, even though know the stock will not turn.
Dead money is dead money. Why tie up your funds if a better chance to re-enter a position is down the road?
Remember: hope is not a strategy
Another reason to sell a losing position — or a position that no longer fits a trader’s initial reason to buy — is that capital is tight and needs to be diverted elsewhere to make or conserve money.
I know it is hard sometimes to admit that a trade went against you, but I always try to think back to the days of being a medic.
Stop the bleeding. It does no good if the position bleeds you dry while you are waiting for the cure.
Remember, traders should always consult a tax advisor for any tax-related issues.