A Financial Revolution 

March 18, 2006
Sell Losers Short Term, Sell Winners Long Term
It's time to confess... I made a mistake last year. I tried a small experiment with the dogs of the Dow - investing in the six highest-yielding stocks in the Dow Jones Industrial Average and selling after one year. Historically, this approach bests the performance of the Dow by about 50%. The results for my holding period were not stellar - about a 0.5% gain after commissions.

My mistake, however, was selling all the positions after one year. By holding them for more than 365 days, the gains/losses were considered "long term" for tax purposes and taxed at 15%. I should have sold the losing positions in SBC Communications and Verizon Communications a week earlier for a short term loss. Making this little change would have yielded a loss that could be deducted from my short-term gains that are taxed at just shy of twice the long-term rate. Here are the options expressed as formulas:
  • Tax savings from selling short-term losses = loss X 0.28 tax rate
  • Tax savings from selling long-term losses = loss X 0.15 tax rate

Which do you think is the better option? Fortunately this was a small-money experiment, but it provided a valuable lesson: sell your losers short term and your winners long term (if at all.)

Update: As THC points out below, if you have net short-term losses, they can be used to offset net long-term gains. If the end result is a net loss, you can use up to $3,000 per year to offset ordinary income (you can carry over any excess losses to future years.)

Anonymous thc said...

Jeremy: I think that you're are mistaken about the taxation of capital losses. Losses are netted against gains and, if there is still a net loss, it can be taken against ordinary income to the tune of $3,000 per year. The rest is carried forward to future tax years.

Also, the Dogs of the Dow strategy, like any equity strategy, is best over longer periods. The way it's supposed to work is you only sell those positions that are no longer among the top ten highest yielders. You then replace them with the new members of the group. Some years there are no changes, most years there are very few, so it's a pretty tax-efficient strategy as well.

3/18/2006 4:35 PM  

Anonymous Jeremy said...

Hi THC, you are correct about ST offsetting LT. It wasn't clear in my post that I had some short-term gains from a couple going private transactions. Those gains were taxed at 28% while my losses moved into the long-term category.

As for the Dogs of the Dow. I recognize that it is a long-term strategy, but I told myself I was going to experiment for only one year. Too short? Probably. Nonetheless, that was the rule I set for myself. At the end of the year I looked at my holdings and asked myself if I thought any of the stocks met my regular investment criteria. For most, I had to say no and sell.

3/19/2006 9:04 AM  

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5/02/2006 12:43 AM  

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