I’ve been doing quite a bit of reading on the subject of Behavioral Finance of late (and will only being doing more and more in the future). I haven’t been in the academic finance arena since I did my MBA in the late 90s, so some of what I’m going it refreshing my knowledge base and reaquainting myself with the academic viewpoint. It’s really easy to slip away from that when you’re focused very closely on real world markets and regularly interacting with real-world traders, not just the ones imagined in the academic literature. (On the Behavioral Finance subject, I encourage you to watch Mind Over Money.)
One of the things that has come up fairly frequently in the articles and papers I’ve been reading is the idea of cutting your losses and letting your profits run. Now this is an academic discussion, so it has relatively little to do with what most traders think when that sort of advice is being offered. Instead, the academics are referring to the tax implications, especially since they most often are referring to stock trading/investing.
Here’s the logic
When you close a position you trigger a tax event. If you exit a profitable position you’ll have a tax liability – obviously – so it behooves one to hold on as long as possible to defer that event. This is particularly true near year-end when a shortly extended holding period can defer a tax bill by 12 months or more.
As for cutting your losses early, that’s the flip side. When you take a loss you reduce your tax liability. That means it behooves you to book your losses quickly. In effect, the tax impact reduces your net loss. For example, if you’re tax rate is 20% and you’ve taken a $1000 trading loss, you’ve effectively only lost $800. In other words, your account is effectively worth $200 more if you take that loss than if you hold on to the trade. The academics I’ve read seem genuinely incredulous that traders and investors would hold losing positions for exactly that reason.
Know the Law
Now there are all kinds of different tax rules in the global array ofÂ jurisdictions and markets. For example, in the US securities (stocks, bonds, options, etc.)Â fall under normalÂ capital gains where the tax impact is only felt when a trade is closed. Futures and forex are treated differently in that your positions are marked-to-market at year-end. That means the timing of your exits doesn’t really matter. The rules are different in other countries, though, especially when you bring in things like spreadbetting, so make sure you know how your country’s tax laws impact your bottom line.