Even though capital gains taxes make selling appreciated securities less attractive, there are often compelling reasons to reduce or liquidate a position. The two most common reasons to sell appreciated stock are to increase portfolio diversification and boost long-term returns.
Capital gains taxes are the main deterrent to selling a stock which has appreciated in value relative to its purchase price. The Federal government currently assesses a maximum combined long-term capital gains/investment income tax of 23.8% on appreciation that has occurred more than one year from date of acquisition. Stock holdings sold one year or less from date of original purchase are subject to ordinary income tax of up to 40.8%. Depending on the investor’s domicile, states can assess additional capital gains taxes which range from 0% to as high as 13.5% for high income earners in California and New York (NYC residents). Therefore, the combined tax could be more than 37% on long-term holdings and over 50% for short-term holdings.
Congress is also contemplating increasing income tax rates to almost 40% and taxing all capital gains at the same rate as ordinary income. If these proposals become law, capital gains taxes could potentially exceed 50%. Given the high rates of return (Russell 1000 compounded 14% annually for 10 years) since the financial crisis ended in early 2009, many stocks have appreciated substantially. Therefore, the gains associated with selling such stocks are large and the taxes quite high.
However, selling a stock that has become too large a portion of a portfolio will increase the overall diversification of that account. Reducing that stock’s size will also protect against unexpected losses that can potentially strike any company. For example, Fannie Mae was viewed as a blue-chip company going into the financial crisis and traded for $60-70 per share. From 2007 to 2008, the stock crashed and bottomed out at $0.30 per share as the company entered receivership as homeowners defaulted on their mortgages. Looking back, any investors in that stock would have been glad to realize capital gains before its crash, pay the tax and reduce their exposure. There are countless other examples of severe losses in individual stocks which appear to strike from the blue.
Stocks with extremely high valuations tend to have much lower long-term returns going forward compared to those companies with more reasonable price points. Therefore, selling appreciated stocks and paying the tax may boost long-term returns. Assuming a 37% combined capital gains rate and an unrealized 100% appreciation in Stock A, consider the following example. Stock A is sold, the capital gain is realized and only the after-tax proceeds are re-invested in Stock B. If Stock A appreciates 5% annually for the next 10 years and Stock B appreciates 10% annually over the same period, then it makes sense to sell Stock A and invest in Stock B. Given this return spread, investing in Stock B would be worth more than keeping Stock A after about 5 years and 30% more after 10 years.
Aside from valuation, many factors could cause this disparate performance. The market for the company’s goods or services may have changed such that the opportunity diminished. A legal or regulatory change could also disfavor its prospects. Additionally, there could be an Environmental, Social or Governance (ESG) rationale for selling a security and swapping into a new stock.
In conclusion, buy and hold investing can be a very valid strategy. It often takes time for an investment thesis to mature, and the tax consequences of selling are significant. However, a prudent level of portfolio turnover and thus capital gains realization can enhance diversification and improve investment performance.