Stocks do not move in a linear fashion. Stockdisciplines.com traders have found that if a stock is up 20% in 5 months, it is unlikely to be up 40% in 10 months. It is more likely to be up 8% in 10 months or even down 10%. Hence, the key to higher net returns is to base investment decisions not on the nature of our tax code but on the proper weighing of risk against reward. If all things were equal, it would generally be better to hold for the longer term. This is obvious, and it is our own preference. However, all things are rarely equal and stock patterns do break down. When a stock begins to drop, the preservation of capital is much more important than getting a lower tax rate. Those who invest by the tax code rather than by the signals given by the stocks themselves often end up paying less in taxes because they don’t make any money. They get the deductions they long for (a lot of losing positions) but not the profits. The priority should be to make money in the first place and after that to have your CPA help you keep it from being taxed away.

The fact is that no one can say for sure that none of the stocks in a given portfolio will plummet out of existence (even if they are all blue chips). Of course we would all like to buy nothing but steady climbers and leave them in the portfolio for a year or more to get the long-term capital gain tax benefit. Five years would be even better because it would reduce transaction costs. However, the market and your stocks do not care about your wants, needs, or tax status. Also, transaction costs can be minimal. At one well-known discount brokerage firm, for example, it is possible to sell out a position worth $50,000 for only $7. If the stock price is $40 a share, the brokerage commission for this trade would come to little more than half a penny per share. This cost is insignificant relative to the loss that could be incurred by keeping a loser.

If we buy a stock and it starts to break down shortly after we purchase it, we must admit that either we were wrong or that the unforeseen has occurred. Certain conditions and requirements had to be met by the stock and/or the company for us to buy it in the first place. If those conditions no longer exist, we must sell. Our prime consideration in a volatile environment must be to preserve assets, even if we have to sell a stock the day after we bought it. On the other hand, if we achieve a return of 20% in 6 months and the stock is still strong and still close to support, we will continue to hold because we have not been given a reason to sell. The same would be true if we had held the stock for 5 years and our gain were much greater. The stock itself, or the market, will tell us when we must sell. Volatility-adjusted stop losses are extremely useful in this regard.

There is no way to know in advance how long a given stock should be held. We should not invest on the basis of what we think ought to be but on the basis of what is. Though a 1-year minimum holding period is desirable for tax considerations, it is meaningless and arbitrary in the context of market behavior. In fact, rigidity in our thinking along these lines can be very costly. Of course we want to hold a stock as long as we can, but rate of growth and risk should not be ignored. A stock that has proven itself incapable of breaking through overhead resistance no longer has growth potential, and continuing to hold it involves risk of loss (the risk/reward ratio has changed). In fact, risk of loss will increase as others conclude the stock will not go higher.

It is difficult to leave behind old concepts of investing. It is one thing to be aware that a particular stock has given a sell signal and another to break loose from old ways of thinking in order to act on that signal. This is something that takes time to internalize to the point where it is automatic. A good, well-articulated discipline can be an effective trainer in this regard. There are, after all, lessons to be learned from every plummeting stock and every market crash. Investors must learn to allow stocks and the market to give their own signals. When those signals are given...we must learn to listen.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

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