(Sam Swenson, CFA, CPA)
As of this writing, it appears that S&P 500 Stocks eventually entered a bear market or hit levels 20% below their previous highs. While this is disconcerting to even the most stoic investor, and especially if he is retired or retiring, there are plenty of good reasons to leave your portfolio alone as much as possible.
Let’s look at three of the best reasons to avoid selling stocks during a stock market downturn.
1. You will keep your waiting periods
Stocks held for more than a year are eligible for long-term capital gains tax rates, which are significantly more favorable than their short-term counterparts. If you sell shares after they’ve lost value, you’ll reset your holding periods when you re-enter the market, meaning you’ll have to wait an additional year to requalify for long-term treatment.
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By refusing to sell in the middle of a recession, you will keep your existing holding periods. This can benefit you in the event that you are able to sell at a profit when the market returns to its previous levels, and will also bring you closer to qualifying tax treatment on any dividends you may receive. If you can hold stocks, mutual funds, or other securities for a specified period of time, you’ll also have the opportunity to pay lower taxes on dividends received.
2. You will take advantage of the reinvestment of dividends
It is interesting that most people want to run away from the market when it is falling, but will also run towards it when it is overvalued. While stock market declines are clearly not good for your portfolio foundation, they do present valuable opportunities to buy.
To that end, dividend reinvestment occurs when dividends are paid and then automatically reinvested; the long-term opportunity is magnified if this happens after a market crash. If you receive a dividend after a market correction, your dividend will be reinvested at a lower price and, in turn, you will buy more shares than you otherwise would have.
This often happens “behind the scenes” if you’re not constantly monitoring your account and have dividends set to automatically reinvest. But it proves to be a valuable strategy for replenishing your account balances over time.
Below is a chart of the performance of the S&P 500 since 2010 with (% change in price of total return) and without (% change in price) reinvesting dividends:
3. You will avoid acting on emotion
Any time you sell stocks in a panic, you’re acting on short-term market movements and likely abandoning a long-term view for your finances. This is not a wise investment strategy, as markets are inherently volatile and tend to fluctuate for a wide variety of (unpredictable) reasons.
A more sustainable course of action comes from carefully constructing a financial plan, ideally in writing, and following it to the best of your ability. This often means evaluating your goals and life circumstances, dividing up an emergency fund, and developing an appropriate asset allocation. Having a plan ahead of a market downturn can really go a long way in keeping your emotions in check.
Review your financial plan
Let’s face it: no investor likes to see the market give up more than a year of gains. It is painful. But it is something that we will all have to get used to if we want to invest in the financial markets and obtain long-term benefits.
Having a long-term plan and acting on it is really the best way to increase your long-term wealth. Getting the most out of your investments often comes down to doing a few basic things on a consistent basis, including investing regularly, managing your taxes, reinvesting your dividends, and avoiding being purely emotional.
If you commit to a long-term plan with an adequate emergency fund, you’ll feel less like selling when the going gets tough.
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