Undo

Mar 23, 2007 by

TheBluestButterfly asked me to write about how to get out of an investing mistake. Imagine you have made an investment that you now regret making. Should you wait for the investment to correct? How quickly should you reinvest the money? What are the factors to consider?

Fixing Investing Mistakes in a Tax-Free, Commission-Free World

Imagine that you live in the nation of Libertaria, where people are free to buy and sell things without short-term capital gains tax consequences. Your online broker, Freetrade, charges you $0 in commission for each trade. How should you behave? In Liberteria, you should only own stocks that you think are going to outperform the market’s expectations in the future. The moment you believe a stock will underperform the market’s expectations, you should sell it.

In a tax and commission-free world, there is no reason to ever hold a stock that you do not believe in. In this theoretical world, the optimal behavior would be to sell all of you stocks every minute, and then one instant later, re-invest your money in the portfolio of stocks that you believed would be optimal for the next minute. If you believed that the stocks you previously held in your portfolio were optimal, you would simply rebuy them to hold for the next minute. If you did not feel your previous portfolio was optimal, you would adjust your holdings. If you behaved in this manner, none of your investing “mistakes” would persist for more than one minute.

Note that I use the word expectations.¬†Imagine company A is expected to go from $3M in profit/quarter to $3.1M in profit/quarter over the course of a year, while company B is expected to go from $1M in profit/quarter to $1.1M in profit/quarter. At the end of the year, company A is producing $2.8M in profit/quarter, while company B is producing $1.2M in profit/quarter. Whose stock went up? Company B’s stock went up, as it outperformed expectations, even though it generated less profit per quarter than Company A. Company A’s stock is likely to have declined over the course of the year, as the market originally had priced it on the expectation that it would achieve $3.1M in profit/quarter, which it did not. If you were an investor in a market containing Company A and Company B, you should have sold Company A the instant that you felt it would underperform what the market as a whole had expected. Likewise, you should have bought Company B if you felt that it would outperform its expectations.

Fixing Mistakes in the Real World

We all know that we don’t live in Libertaria, and that it does not make sense for an individual to reconfigure his investments on a minute-by-minute basis. There are really three factors that make this theoretical ideal not a practical ideal. First of all, people have to pay higher taxes on short-term capital gains (increases in investment value) than on long-term (over one year) capital gains. If you liquidated and repurchased your portfolio continuously, you would get hit with short-term capital gains taxes. Second of all, whenever you trade, you are charged a commission, often between $7 and $25, depending on whether or not you use a discount brokerage. Thus, if you sold and rebought a stock every minute, you would generate $7*2 = $14 in commissions every minute! Finally, as a result of the bid-ask spread, at any instant in time, the purchase price of a stock is slightly greater than the money you can receive from selling it. As a result of all of this friction in the market, people do not always instantly sell their stocks the moment that they do not feel they will have a bright future.

Balancing the Ideal World with the Real World

As an investor, it is imperative that you balance your perception of a stock’s expected outcome with the friction cost of the market. Imagine you own 100 shares of XYZ, valued at $10/share. The market is still open, but you imagine that due to an event not widely known by the market, the stock will be trading at $9.90/share tomorrow. Should you sell your shares and re-buy them tomorrow? Imagine your brokerage charges a $7/transaction commission.

If you sell your shares, you will only be able to receive the “bid” price for them, which will be lower than $10/share. According to your broker, the current “bid” price on your shares is $9.97/share. So, if you sell your 100 shares, you will make $9.97 * 100 – $7 = $990.

The next day, you wish to take a 100 share stake in XYZ. As you predicted, the stock is at $9.90/share. Unfortunately, the “ask” price is above this; it is $9.92/share. Buying 100 shares will cost you: $9.92 * 100 + $7 = $999.

Thus, in this situation, by selling a stock at “$10/share,” and then re-buying it at “$9.90/share,” you have managed to lose $990-$999 = $9!. This calculation has not even taken into consideration the tax savings you might have made on your capital gains had you held the stock longer. The bottom line of this scenario is that it is only sensible to “churn” (rapidly buy and resell) a stock if you feel that its value will change substantially enough to offset the cost of doing so. As an investor, you must carefully balance the desire to churn stocks instantaneously to always have the best portfolio for the moment with the desire to hold them in order to avoid friction costs.

3 Comments

  1. Capital tax gain are by their nature a brake on the economy they slow down trend which is bad and they punish those who instead of sitting on their money take the risk to support the economy which is worse. Most peoples who invest on the market know this. The only reason Tax Gain on Investment exist is political.

  2. Liz

    On the other hand, if you had 1000 shares under your hypothetical scenario, you’d have made $36 from your various trades. Churning stocks is less onerous for a large investor, simply because the trading fees make up an insignificant percentage.

    You also have to take into account your personal forecast for the unwise investment you’re holding. If you think a simple correction will happen (i.e. stock is overvalued by $x, but then should stabilize), going through this sort of optimization makes sense, particularly when you complicate it further with capital gains tax. If, though, you perceive that the stock is on a steady decline (losing y% of its value each day), then getting out sooner rather than later will always be the right choice.

  3. Mr Hughes

    That’s a nice article! Balancing on the edge of the real world and Utopia is actually a key to lots of stuff not even related to investments. In regards to the investments topic: IMHO the desire to have the best portfolio for the time being can harm especially if you are a beginner. The further is the “event not widely known by the market” you can predict, the more goals you score and the less things you need to undo.

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