Question:

Hi Mark

Probably most of us have held shares in a company that has gone bad but held on to the position to avoid real loss. Then there is the opposite where a company we own has been spectacularly successful but then is suddenly compulsory acquired by another and paid out resulting in a potential capital gain tax liability not of one’s choice. Would it be right to sell the poor performer to offset the good performer? Interested in hearing about such situations from various perspectives. However, I found it a good time to rid myself of a poor performer that I considered would never come right regardless of how long I waited. How else could one deal with involuntary capital gains?

Answer:

For readers, this question is referring to an article written on when you should sell shares. 

We hear a lot about what to buy. Nobody ever talks about selling.

I certainly didn't mean to suggest that an investor should never sell shares. Unfortunately shares we own can be bought by another company or taken private which can generate capital gains. Offsetting those gains is sensible. Afterall the focus should always be on real returns after taxes and fees.

I still believe that an investor shouldn’t sell unless their original thesis no longer applies. Selling a share to offset a capital gain that then goes on to triple in price doesn’t make a lot of financial sense.

One of the hardest things about investing is the influence that prices have on our view of the merits of certain investments. We all invest to earn returns so over the long-term it is the changes in prices that matter. But short-term or temporary price changes are not indicative of the long-term merits of an investment and the long-term returns that can be generated from that investment.

I can preach all day about separating the performance of the company from the price but that is extremely difficult to do in real life. I encourage investors to have a thesis (and write it down) each time they buy something. That is because it provides a point of reference when trying to make a decision on what to sell in the situation described in the email.

The thesis doesn't have to be complicated and can just be a couple bullet points. For instance, an investor buying CBA today may believe the shares will continue to perform strongly:

  • Because it is the best run Aussie bank
  • It will take market share from the other members of the big 4
  • And as a result, the multiple on CBA shares will continue to expand

That thesis is concise but it covers a lot of the bases - how the underlying business will perform, why it will perform that way and why this will positively impact the share price. I would hope that further research went into the decision but it captures the essence of why somebody might buy CBA shares.

Down the line when considering if CBA should be sold if the share price drops the investor can check how the bank is doing against that thesis. The investor can try and answer the following questions:

  • Are there are indications that CBA is executing better than rivals?
  • Are there tangible market share gains? Are they sustainable?
  • Is the multiple increasing and will it stay at a higher level?

If the answer to each of those questions is no, the investor can try and evaluate if he or she is wrong or if more time is needed for the thesis to play out. At the very least this approach can slow down the decision-making process and try and remove the emotional reaction from the share price dropping. The more structure that can be put into investing the less influence that emotions play. And reactions to price movements are emotional reaction.

There is no easy answer to any question about investing. As investors we are trying to make decisions that give us the best outcomes. Those outcomes will be determined by an unknowable future. All each of us can do is try and make sure that those decisions are made in a structured way by following a plan that is aligned with what we are trying to achieve.

In a perfect world everything we buy would go up in price. But we are all going to own things that don’t work out. The only value we can extract from those losers in our portfolio is the tax offset and it makes sense to use it. Just make sure that you are selling because your thesis was wrong and not because the ‘market’ is being temporarily irrational.   

Have a question? Write me at [email protected] 

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Articles mentioned:

Previous editions of Mark to market can be found here.