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Today I came up with a reason why selling stocks too early might be a bad idea:

Imagine that we invest $100 in stocks. If we assume a constant annual growth of 10% the after say 50 years, we would have around 100*1.1^50 = $11,739. The capital gain would be of $11,639 and after we payed a 20% tax on it we would be left with $9,411

Now let's imagine another person who invests $100 as well. For some reason he sells and rebuys every year. This person would pay a 20% tax on the 10% capital gain. In other words, he would be getting an 8% annual capital gain after taxes. In 50 years he'd be have: 100*1.08^50 = $4,690

In both cases we are paying 20% taxes on capital gains but the first option is amasses twice as much capital.

This comparison seems to validate the idea that it is much better to let compound interest do its magic on the entire investment without paying taxes until the end.

I am not an economist so I would like to verify that my idea is correct.

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  • Your idea is correct based on the binary choice that you have set up. However, the world of investing isn't binary. Let's try something beyond binary on for size. Trader B just happened to sell his stock and he's not participating in the current 30% drop in the market. Investor A is in the market and is taking the full beating. So what does that do you you calculations. Kaboom! They were just blown up :-) – Bob Baerker Mar 24 '20 at 22:14
  • If we assume a constant annual growth probably a bad assumption – quid Mar 26 '20 at 2:23
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Your general supposition is correct: if you had an imaginary stock that could go up 10% every year, you're better off just keeping the money in, as then you are basically doing what you say (earning 10% on the money you'd be taxed on), and you get to keep 80% of that additional 10%.

However, the real world doesn't work that way - stocks go up and down, and you want to make choices like balancing your portfolio to manage risk. That's why people sell - they don't do it to lock in taxes, they do it to lock in gains and then put the money in other things (either to make different investment choices, or to balance their portfolio's risk).

Finally, there is another consideration. That 20% tax rate isn't going to apply to you necessarily every year, depending on your income level. Let's say you don't have $100 invested, but have $50k invested. In 20 years, you are going to sell all of this to pay for your kid's college. Right now, your income excluding this stock is $350k, and you're married. That leaves you at the 15% capital gains rate, not 20%; and including this, you're still in that 15% bracket. But sell the big chunk in 20 years, and you're going to hit the big number - 20%.

Now, in 20 years you're still better off leaving it sit there - you're ahead by quite a bit ($306k vs $277k). But not nearly as much, no? And you're ahead in the sell-every-year plan up through year 8 (assuming you were indeed going over the limit that year with the sell all at once plan; obviously at that point it's less of a difference in tax rates). I'm also simplifying some here.

Finally, it's also possible that some years you might have, for example, a big capital loss somewhere else - say, you were a big believer in Sears Holdings and had their stock for the last ten years - then you could sell that (to incur the capital loss), sell this also (to incur the capital gain), end up net zero (or close enough), and then buy back in to the successful stock/fund later. This means you make your full 10% and adjust the basis price to the higher price.

In general, I think you're right - it's mostly better to sit on investments that are intended for long-term purposes. But it's not 100% cut and dried, which is why it's not something every person does.

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Essentially correct, which is why it doesn't usually make sense to sell and rebuy the same stock in a short time period. Note that when dealing with losses, this would amount to a wash sale - you can't sell a poorly performing asset to claim capital losses and then re-establish your position immediately (you are disallowed from claiming the loss, since it only really happened "on paper"). But if you sell a well-performing asset to claim capital gains and then re-establish your position, the government is happy to take a cut every time you choose to realize gains.

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    The IRS doesn't disallow wash sale capital losses (as in the sense of losing the deduction). It makes you defer the loss until all positions are closed. This can be avoided by staying out of the stock for 30 days after the loss is incurred. And even so, the worst case scenario is that you defer the loss into the next tax year if it's a carryover loss. – Bob Baerker Mar 24 '20 at 20:46

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