Taking Profits Before the Bear Eats Them

In James’s book The Journey to Wealth, he discusses the importance of protecting your portfolio from bear markets and the “ugly math” that results from experiencing catastrophic loss, as well as the extensive amount of time it usually takes to recover. So what about the tax implications of selling stocks when detecting a bear market on the horizon? Is it worth it to take profits ahead of the certainty of a full-fledged bear?

This is an often misunderstood subject. What if you have built up significant gains in your taxable account? Is it worth selling these profitable investments and paying the capital gains tax versus just riding out the bear market and the years it may take to recover? The answer is: Yes, it is. Our research and experience suggest that it is much better to be a seller and pay taxes rather than experiencing the “ugly math” of a bear market along with the long road to recovery.

Let’s say you had a portfolio of 75% stocks and 25% bonds that rode the bull market wave between 2009 and 2020. Your original investment in 2009 was $400,000 ($300,000 in stocks, $100,000 in bonds). By the end of 2019, it had grown to $1 million, so you have a taxable profit of $600,000! During this time, the average stock increased by a whopping 200% – quite common in bull market cycles! Along the way you took out some profits and slightly reduced your asset allocation to 70/30 (ARM Rule #1!).

Using the rules of SMART investing and Active Risk Management (see The Journey to Wealth), if you sold all your stocks before the losses became catastrophic, you would mitigate further loss but would owe taxes on those sales. As the bear market kicks in, you sell off those sectors most vulnerable, while keeping some stocks in sectors that are defensive in nature – consumer staples, utilities, and healthcare for example. Let’s use a 30% long-term capital gains tax rate (your rate will vary depending upon your tax bracket and the state you live in). And let’s assume you sell off 75% of your stocks. Here’s the math so you can see which strategy makes more sense:

The difference is remarkable in how much you will need to regain to return to your $1 million portfolio – 46% vs. 20%. It is clear that selling off stocks in a bear market, even if you must pay taxes on capital gains, is the better strategy. Also note that in this example we are using a 100% taxable portfolio. If the investor has an equal amount of non-taxable assets (such as an IRA account with no withdrawals needed), the difference becomes even more striking.

Many investors would like to avoid a bear market as well as taxes – but it is just not realistic. It is important that investors accept the idea of paying capital gains taxes during a market cycle to protect profits and portfolio values. Paying taxes almost always makes sense when protecting your wealth from a bear market – and the ugly math and extended amount of time it can take to recover.

Investment advisory services offered through Main Street Research, LLC, a registered investment adviser. The material here is provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness. As such, information in these materials may change at any time and without notice. This communication is in no way a solicitation or an offer to sell securities or investment advisory services.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.