Letting Your Cost Basis Dictate Your Investment Decisions

If you haven't been keeping count, for the past two months we've been discussing common mistakes we make when investing. Here's the shortened list:

· Overdiversification
· Underdiversification
· Euphoria
· Panic
· Leverage
· Speculating when you think you're investing
· Investing for current yield instead of total return
· Letting your cost basis dictate your investment decisions

Let's look at the last mistake, one that I, too, am making begrudgingly with some of you: letting your cost basis dictate your investment decisions.

Sometimes we feel stuck in the investments we already own and it's hard to make a change. Taxes are one of those "sticky topics." Bob has a stock that has grown over a long period of time, significantly more than he ever paid for it. He fears selling the stock because he's avoiding the tax burden.

It's a mistake to let our buy price determine our sale price. But this maxim is so hard to follow! Let's look at Bob's dilemma. One of two things will happen over the next year: Bob will either lose or make money on his investments.

Losing Money

Bob doesn't want to sell his current investment because of the taxes he'll have to pay on the gains. If Bob's investment loses enough money to make the taxes acceptable, he will have given up four times as much as he would have gained. For every $100 in taxable gains today, it will cost him approximately $25 in taxes. If his taxable gains drop by $4, he'll pay $1 less in taxes. In other words, he has to lose four times as much money as he might save in taxes.

By letting his buy price (tax basis) determine his sell decision, Bob is risking a 400% mistake. He's avoiding a sure 25% tax burden, but the only way he can save that money is to lose four times that much. But that's not really going to happen, is it?

You know if the losses become that big, he's likely to repeat another mistake (underdiversification), also know as "I will just hold on until I get back to that high price and then I promise to sell."

Or Bob might lose just a little money, not a lot. He might not lose enough to make the taxes acceptable, whatever that means for him. So he will hold onto the investment and prolong this agony longer. He'll remain underdiversified and have other risks for no good reason, just to avoid the taxes. He'll take a 400% risk to avoid a 25% assured (tax) loss.

Making Money

Bob might make money on the investment over the next (whatever time frame), but not enough to cause him to want to sell the investment. Sometimes I hear folks say, "I'll just hang on until I have made enough money to pay for the taxes." This is another white lie we tell ourselves to appease our greed and avoid tax fear and loathing.

Here are two big problems with holding onto an inappropriate investment (even if it makes money):

First, holding onto an inappropriate investment is foolish. The math says you will need a 33% gain to offset a 25% tax burden. How long will Bob be willing to wait for that gain? And won't Bob's feelings change over time? Unless you luck out, waiting for the gains to offset the taxes is foolish.

Second, holding onto an inappropriate investment is just plain risky. Even if it makes money, even if you avoid paying those capital gains taxes, the investment should be sold because you are in no better shape than you are if the investment loses money. You're still taking a 400% risk to avoid a 25% assured (tax) loss.

But what if the investment makes a lot of money in the future? Clearly, we're holding onto a previous winner, or we wouldn't be allowing our tax basis to dictate our investment decisions.

Again, a little humility goes a long way. Any fool can look at an investment that has made money and say, "Yes, in the past, it made money." But the wise investor says, "The only day we have to invest is today. What is the best place for my money now, based on my goals, values, and relationships? Why am I not putting my money there?"

And the wise investor takes her own advice, sells the inappropriate investment, and makes decisions in alignment with her goals, values, and everything that means the most.

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