By Jonathan Burton, MarketWatch
Nobody likes losing. So why do people hang on to losing investments?
Because selling feels even worse.
The pain of a loss is substantially greater than the pleasure from a gain, researchers of investment behavior have found. People will go to great lengths to avoid pain. Accordingly, our hard-wired inclination when facing a financial loss is to convince ourselves that the asset is going to bounce back and we will at least break even.
“People tell themselves it’s only a paper loss,” says Terrance Odean , a professor of finance at the Haas School of Business at the University of California, Berkeley. “It’s not a real loss until I sell.”
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In truth, the real loss is in not selling — especially when doing so offsets tax on capital gains.
“You’re postponing regret, hoping to avoid it altogether,” Odean adds. “It doesn’t improve your investment return, and it certainly doesn’t help your taxes.”
Mutual-fund investors are uniquely disadvantaged here. Fund holders can be hit with capital gains even if they haven’t sold a single share. For instance, when a stock reaches a portfolio manager’s price target and is sold, shareholders pay the capital-gains tax. Or if a manager sells appreciated securities to cover redemptions by shareholders exiting the fund, remaining investors get stuck with the tax bill.
Harvesting capital losses mitigates the sting. Capital losses may be used to offset capital gains and up to $3,000 of ordinary taxable income. Plus, unused losses can be applied against capital gains in future years.
Fewer losers now
Except in 2014, with the bull market for U.S. stocks well into its sixth year, investors won’t find many tax-loss sale candidates among actively managed stock funds. The average U.S. large-cap blend fund, for example, gained 19.6% annually on average over three years, and 14.4% over five years, as of Dec. 3, according to investment researcher Morningstar.
“It could turn out to be a nasty tax season,” says Christine Benz, Morningstar’s director of personal finance. But “there are losers out there if you look closely.”
Good places to start: Diversified emerging-markets stock funds, Latin America stock funds, commodity, energy, natural-resources and precious-metal funds all have delivered dismal multiyear average returns.
Realizing a tax benefit isn’t the only reason to unload a disappointing fund. You want confidence that investments in your portfolio fit your expectations, and the end of a year is an appropriate time for review.