When to Take Profits

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Contents

How to Profit from a Stock Market Crash

Publish date: March 30, 2020

Table of Contents:

Yes, We’re in a Bear Market

Now, let’s remember exactly what a bear market is.

The market is considered a “bear market” when major stock indices (i.e., the Dow Jones) have dropped 20% from their high. The 20% mark is an arbitrary number, but the more important thing is that it designates that the stock market has reached a low point. We’ll discuss this further in the next section.

The Dow Jones peaked on February 12th and has since dropped 27 percent, while the S&P 500 has dropped 20 percent from its peak on February 19th. This definitely indicates a bear market, close to one not seen since the 2008 recession.

The biggest driver of this decline has been the coronavirus, which was officially designated a pandemic by the World Health Organization. It also doesn’t help that we’re in an election year, which is making things extra shaky.

As it looks right now, we’ll be in a bear market for the foreseeable future. Though, it may feel a bit like a rollercoaster with the recent ups and downs. Which leads to the next point–how you should be constructing your portfolio right now.

What is a Bear Market?

Generally speaking, a bear market is when the cost of a financial investment falls a minimum of 20% or more from its 52-week high. For example, if the Dow Jones Industrial Average hit a high of 27,000 and then fell 20%, to 21,600, it would be considered in a bearish market. In stocks, a bear market is measured by the Dow, the S&P 500, and the NASDAQ. In bonds, a bear market might take place in U.S. Treasuries, corporate bonds, or municipal bonds.

What Are the Benefits of a Bear Market?

Cheap Stocks = Massive Gains Over Time

If you act effectively, by not selling and rather continuing to purchase stocks, the more bear markets you experience as an investor, the higher the probability that you’ll eventually retire with a bigger nest egg. In other words, years of underperformance tend to be followed by years of overperformance. And those years of underperformance are an excellent opportunity to purchase shares inexpensively.

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You can open a regular ‘ole trading account or an IRA (both Roth and Traditional).

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Other Investors Are Scared of the Stock Market

There is a simple reason why so many investors and even professional money managers are scared of the stock market–in the short term, stock prices seem arbitrary. Up one day and down the next, watching the ticker every second the market is open can cause one to wonder just what in St. Peter’s name is going on. Warren Buffett described this phenomenon like only Warren Buffett can:

“In the short run, the market is a voting machine but in the long run it is a weighing machine.”

Actually, Benjamin Graham first said this, and it has stuck with Mr. Buffett, who repeats it often. But the wisdom behind this statement should be taken to heart.

In the short term, stock prices reflect all kinds of noise. The Fed Chairman says this or that, and stocks fluctuate. Unemployment numbers come out, and the market reacts. A politician says something to get elected, and the stock market traders do their thing. The point is that in the short term (I’d say one year or less), stock prices are often the result of factors that do not bear on the long-term value of the enterprise.

When viewed long term, however, the market truly does reflect the underlying value of public companies. By long term, I mean really long term (ten years or more). Stocks can be undervalued or overvalued for a decade (see 1960s or 1990s). But given enough time, stocks will reflect the underlying value of the corporation that issued the security.

Investors Sell on Fear and Buy on Greed

While most would not quarrel with the above comments, many do not take them to heart. It is not easy to hold on to your investments when they fall 40%. You start to lose confidence in your investing decisions. Then you start to wonder if there has been some seismic shift in the markets.

Remember the Internet bubble? I recall investors talking about how the world was totally different with the Internet, and they used this lie to convince themselves to buy stocks of dot com companies with zero revenue. Remember the housing bubble? Folks would tell me that they are not making any more land, so prices must keep going up. Those folks are renting now and proclaiming that owning a home is NOT the financially prudent thing to do.

The point is that many investors do exactly the opposite of what they should do. When stocks are going up, they buy, buy, buy. When the markets crash, out of fear, they sell, sell, sell. All I can say is that this is wrong, wrong, wrong.

You Learn Your Own Risk Tolerance

A market crash presents a great opportunity to determine just what your risk tolerance is. Many mutual fund companies and brokerage houses offer a short survey to help you determine your risk tolerance.

The survey asks questions like what you would do if the market fell 20%. Would you sell, do nothing, or buy. Once you’ve answered these questions, the survey suggests an asset allocation based on your answers.

Those surveys are all well and good, but there is nothing like losing $10,000, or $100,000, or even $1 million to really gauge your risk tolerance. So after this market crash, you should know your risk tolerance very well. If you sold your investments over the past month or so, you may want to revisit your asset allocation plan. It may have been riskier than you can bear.

Intelligent asset allocation is the essential determinant of your investment returns. Handling more risk, by allocating more to stocks, leads to higher returns over the long term. We all know this.

But look, there’s no way to know how you’ll feel or how you’ll act after losing a substantial sum of cash in the stock market. So how much can you tolerate without losing sleep and bailing on your investments during a bearish market?

Among the most crucial things in investing is to understand your own self, which includes your investment behaviors. This is because we tend to be our own worst enemy. Going through a bear market is truly the only way to discover the appropriate asset allocation for oneself and what he or she can realistically handle (both mentally and financially).

Sound money management includes investing for the long term. As difficult as it may be, this means not making investment decisions based on fear. So let’s hear how you have handled your investments during this down market.

How to Profit from a Bear Market

The simple and easy way to profit from a stock market crash is to do one of the hardest things in life: nothing. “Don’t just do something, stand there!” is the best strategy, in my opinion.

Of course, this assumes that your asset allocation plan is appropriate for your investing horizon and risk tolerance. It also assumes that your investments have gone down because the market has gone down, not because you invested in some silly dot com company with no revenue.

So that’s what I’ve done. I’ve not changed my asset allocation plan. I have continued to invest on a regular basis just as before. I’ve only sold one fund, and that was for tax reasons. The proceeds will be going right back into the market to maintain my asset allocation.

That being said, there are some strategies you can take if you want to accelerate your path to financial freedom during a bear market:

1. Max Out Your 401(k) Right Now

One lesson from the bearish market of 2007 to 2009 is that if you purchase index funds at routine periods through a 401(k), you’ll succeed when the market rebounds. Those who utilized this strategy didn’t understand whether the bear would end in 2007, 2008 or as it finally did, in March of 2009.

So if you haven’t already, it’s time to bump up your contribution to max out your 401(k) this year and moving forward.

Think that’s nuts? Think you can’t afford it?

I still remember a relative who informed me that their 401(k) was cut in half by the time the last bear market ended, but all of the shares purchased en route ended up being insanely profitable when the market finally reversed and climbed higher.

By 2020, those who hung in there (like my relative) have made massive money from the cheaper shares bought during the slump. Now, throw in company matching and all of the cash dumped into the account from that, plus the shares purchased before the peak in 2006 to 2007, and you can imagine how much a portfolio could grow.

Now, it’s probably not smart to go all-in at any one time, but simply to keep investing small amounts at routine periods. After a while, you won’t even miss the money and your portfolio will be growing exponentially behind the scenes.

2. Look for Stocks That Pay Dividends

While the stock’s price is dictated by buying and selling in the stock market, a dividend comes from a company’s net income. If the stock’s price decreases, yet the company is strong, making a profit, and still paying a dividend, it becomes a great option for those looking for additional earnings.

Finding dividend-paying stocks is one of the core tenants of value investing. Just make sure you know what you’re looking for and don’t just pick a random stock because it pays a dividend. There is a method behind the madness here.

3. Find Sectors That Tend to Increase In Price During a Bear Market

It’s useful to research past bear markets to see which stocks, assets, or sectors actually went up (or at least held their own) when, all around them, the market was tanking. Numerous financial websites publish sector efficiencies for different time frames, and you can easily see which sectors are presently outshining others.

Start to designate a few of your investment dollars in those sectors, as when an industry does well, it typically carries that out for an extended period. Bear markets can also have various catalysts, so this strategy can likewise help investors to designate their investments accordingly.

4. Diversify and Shuffle Sectors by Using ETFs

It’s no secret that various sectors do well throughout the ups and downs of economic phases. For example, when the economy is seeing an uptick, a business that sells big-ticket products such as technology equipment, cars, green home improvement, healthcare innovation, and other comparable big purchases, tend to do so effectively. Because of this, so do their stocks (these are described as cyclical stocks).

When the economy looks like it’s getting into an economic crisis, it pays to change to protective stocks connected to basic human needs, such as food (i.e. grocery stores in the consumer staples sector), blue-chip energy stocks, and even clothing and some real estate (depending on where they’re located and who the target audience is).

So utilizing exchange-traded funds (ETFs) with your stocks can be a great way to include diversity and use an industry rotation technique.

5. Buy Bonds

Buying bonds is a great way to offset a bear market. Remember that a declining market typically occurs in difficult financial times. It often exposes which corporations have too much corporate debt to take care of and who is generally doing a pretty good job of dealing with their debt.

But how do you know where to start?

First, it’s helpful to know who issues bonds:

  • Treasury bonds are issued by the federal government.
  • Municipal bonds are issued by cities, states, and regional governments.
  • Corporate bonds are issued by individual companies.
  • Agency bonds are issued by government-sponsored enterprises like Freddie Mac or Fannie Mae.

Second, there are several places to look to buy bonds:

  • The U.S. Treasury: You can buy bonds directly from the government through the Treasury Direct website.
  • ETFs: You can buy bond funds through your existing broker to get a broader diversity and lower cost in bonds. A couple we like are the Vanguard Total Bond Market ETF (BND) and the Schwab U.S. Bond Aggregate ETF (SCHZ).
  • Your broker: You can buy bonds directly through some brokers, such as E*TRADE and TD Ameritrade, but the process can be a bit more cumbersome. I’d only recommend this if you already have a brokerage account with one of the firms that sell bonds, and even then, I’d consider looking at the Treasury Direct site first.

Finally, there are a few key things to look for when buying bonds:

  • Credit ratings: The bond rating is a widely viewed snapshot of a business’s credit reliability. The rating is assigned by a third party bond rating firm (for example, Standard & Poor’s or Moody’s), and a rating of AAA is the highest possible rating available.
  • Bond duration: A bond’s duration is an indicator of how sensitive it’ll be to market rate changes. A longer duration may signify more ups and downs when rates change, since the value of a bond decreases when rates go up.
  • Additional fees: Make sure you’re not paying (or you’re at least aware of) additional fees charged by your broker when buying bonds. As I said above, you may be better off buying them directly through the government.

While this article certainly isn’t intended to be a full breakdown on bonds, this should give you enough information to get started in buying one of the better safeguards against bear markets. For more information, though, you can read our guide on bonds.

6. Short Underperforming Stocks [Advanced]

This one is for advanced investors only, and shouldn’t be attempted by novices. Short-selling is when you borrow money to buy shares of a stock, then immediately sell them. The goal then is to buy them back at a lower price, return the shares to the lender, and make a profit on the difference.

Shorting a stock is super-risky, and you’re essentially rolling the dice. Even the best investment analysis won’t guarantee a stock is going to decline in value, but in a bear market, thorough analysis can certainly help.

7. Buy Dividend-Paying Stocks on Margin [Advanced]

Another advanced technique is buying stock on margin. You have probably seen this in your online brokerage account–the ability to use margin. Margin is basically a loan you get from your brokerage, up to a certain amount, to buy stock.

Why would you do this?

Well, if you can find stocks that are beaten-down, but still pay a dividend, you might be able to buy a bunch of shares on margin (not using your own money) and hope they appreciate in value. Plus, you add in the bonus of dividends.

Best-case scenario–the stocks rebound and you can sell them off, repaying your margin balance and profiting in the meantime. Worst-case is that the stocks continue to decline and you hope that the dividends can help recoup some of the cost.

Buying on margin is risky, so you have to know what you’re doing. But if done correctly, you can be super successful in a bear market.

Other Things to Consider in a Bear Market

Timing the Stock Market Is a Fool’s Game

I have a friend who sold all of his equity investments (a 7 if not 8 figure portfolio) earlier this year before the market crash. At a party at his house the other day, friends were congratulating him on such a wise move. So I asked him if he was going to get back into the market now. He said no. Then I asked when he was going to get back into the market. He did not know. So I reminded everybody that his decision to sell will have been a good one only if he buys at the right time, too.

Successful market timing requires you to be right twice–once when you sell, and once when you buy. And over the lifetime of an investor, you must be correct over and over and over again. Good luck.

What If I’m Hoping to Retire Soon?

Regardless of whether we’re in a bull or bear market, you should have a healthy emergency fund stacked up to protect you against fluctuations in the market and major changes in life. Once you’ve done that, you should make sure your portfolio is well-diversified. Finally, just because you’re diversified doesn’t mean you have to take on a huge amount of risk.

If you’re close to retiring (early or not), you should adjust your asset allocation based on your risk tolerance and runway to retirement. So basically, if you’re retiring in a couple of years, you may want to lean more heavily on safer investments like bonds.

Other Questions to Consider

Bloomberg outlined six key questions to consider before we enter the next bear market. I won’t solve all of these for you here (nor could I), but they are excellent questions for you to think about now, before the bear market hits:

  1. How bad will things get? Typical bear markets see an initial decline of 10 to 20 percent, but things can (and have) gotten much worse. Do some research on historical bear markets to build your knowledge.
  2. Will emerging markets outperform the U.S.? We can’t know this for sure, but it’s smart to include emerging markets as part of your asset allocation, but keep a close eye on things like the trade war and the news in countries that are considered emerging markets.
  3. Will actively managed funds outperform index funds? My opinion is no, but that may not be true. In some cases, actively managed funds can weather the storm of a declining market. But don’t forget, you’re paying a premium for this.
  4. Will managed futures provide positive performance in a down market again? You should only really be looking at futures if you’re an advanced investor. If you are, though, knowing how they’ll perform in a bear market is definitely something to think about, since it’s an opportunity to advance your portfolio.
  5. Will commodities provide diversification benefits? I think commodities are a great idea for diversification in a bear market, but they may not be for everyone. Do some research here.
  6. How will cryptocurrencies react? Crypto wasn’t really a thing during the last bear market, but now it is. This is a huge unknown, so consider it a high-risk, high-reward strategy to invest.

Don’t Forget CDs

When a bear market is tanking your portfolio, things like CDs are looking more and more appealing. To be clear – I do NOT advocate for panic-selling. Meaning, don’t sell off your stocks because of the bear market. In fact, it’s a great time to buy stocks.

That being said, it helps to bolster your portfolio with something with a stable, guaranteed return, like a Certificate of Deposit (CD). In fact, you can get close to 2.00 percent APY on a 1-year CD right now.

My advice is not to go crazy and make CDs a huge chunk of your portfolio, but it might not be a bad idea to get yourself a guaranteed rate of return while the stock market is getting pounded.

Bottom Line

There’s a lot to think about with a bear market. Make sure you listen to The Dough Roller Podcast – Episode 320 – where Rob discusses this in great detail and gives even more insight than I have in this article.

The truth is, we can’t predict the market, nor can we predict what will happen. But what you need to do is prepare and make sure you stay the course, if not increase your investment efforts. A bear market is an amazing opportunity, despite what it sounds like.

Article comments

You make some excellent points in this article. I believe that one of the most important things you can do for yourself in a stock market crash is to have a good understanding of exactly what you’re getting into, that is are you investing or are you speculating. I just finished reading The Big Gamble and it really opened my eyes as to the differences and how to use this new knowledge to invest successfully during these poor economic times.

I congratulate your friend on unloading before the crash. If he did it by dumb luck, he won’t get back in at the proper time. If he did it following good analysis, don’t worry , he will certainly re-enter at the proper time. ” buy and hold” is “buy and hope “-very hard on the nerves as well as the pocket book!

I, like most, invest through my 401K, dollar cost averaging. Naturally I just increased my contribution. We will likely never again get a chance to invest at DOW 9,000 (or 8,000). In 5 years, when the DOW is sitting at 20K or above, we can sell at our lesure.

Bottom line: it’s easier to buy at the bottom than sell at the top, so right now buy with everything you possibly can!

only those people can get benefit from Crash Stock exchanges who were away before crash. But if some one is involved in buying and selling then there is no way one can get away from losses. It’s like a settling elephant, when he sits many lilttle ones get smashed.

Any ways thanks for sharing your view. Although you are not a financial expert.

I totally support the view of Martin, only well informed and wise stock brockers/ investers took their money away from the market. Other wise there’s no chance of escaping from the Financial Tsunami.

Ha ha ha I like the term … Financial Tsunami…..

The captal market will come back and soon every thing would be fine and many new enterants will see the new era.

Congratulation ……
Barak Obama is new President now. Stock Market crises gonna over now

This article did not define what the indicators should be when the stock market turns from bad to good. Getting back in at the proper time is critical. The economist for example only realize when the market is good or bad a year after it started. Should we be waiting for it to reach 9000 points? Maybe it should be after profits for the company you like to invest in start going up. Should we watch the amount of raw materials sales such as iron, copper, cement and wood? Maybe it is something else?

There’s a global food shortage in case you haven’t heard.

Global food shortage + global financial meltdown + natural disaster or a big September 11th type attack will render all of of the financial assumptions listed above as worthless… financial planners the world over will be wheeling their wheelbarrows full of their share market portfolio certificates around, desperately hoping to trade paper for food.

If you want to eat stock certificates then that’s your business but if I had money to invest right now I’d buy grain and then gas it so it can be stored for the medium to long term. Then I’d quietly go about my modern Western lifestyle, suffering on through this downturn, knowing that my investment is actually worth something compared to the hype of shares.

It is now 2020. If you had invested in grain, your investment would have rotted in the silos by now. If you had invested in gas, you would have turned a small profit. If you had invested in stocks, you would have profited very nicely indeed! Stocks always win over the long term!

Hahaha, what a piece of bull, this is kind of con game article that’s has been circulating ever since the inception of the mutual fund investing for suckering uneducated investors in. Yes, stocks eventual do go up, but it’s literately a ponzi scheme, where the initial schemers and insiders already know when to pull the plug, and the retail investors always get the short end of the stick. Notice that stock has to go up because the paper money value over a long period of time keeps going lower and lower, so how’s that gonna make anybody any money when your one dollar is worth a lot less in next ten year’s time? Besides, the stock is a non physical paper note or a digital blip, nothing more, you are paying your hard earned money into this gigantuan con and you have no control over when the insiders gonna do to your money. These people know what much you pay for the stock and how much they would cut you under. The underlying value, PE ratio, fundamentals of the company is irrelevent, because it’s all an illusion and cooked books. I rather buy an antique then buy a piece of stock of which it has not value whatsoever….. but …..shhhhh….. don’t tell that to the million of 401k suckers…..

I don’t agree with your advice to do nothing when the market crashes. I say first decide if have enough money to live on if you lose your job. Then throw the rest of the money in the stock market once it falls 40% or more from its peak. Those are some great buying opportunities. That’s what I did, and it worked.

Of course, you don’t want to marry a stock. Diversify and invest with in mutual funds or ETFs. You can double down on stocks as long as you’re diversifying.

Even during a period of Stock market crash, everyone who sells at the higher price before the crash gained. The buyers who bought at the crashed price gain if the price goes back up. Those buyers could also lose if the price keeps going down or the company goes out of business. Since prices go up and down every day there is no way to identify who wins or loses because of one crash. Remember some buyers buy over many years and may have dividends that more than make up for any one day of crash. People buy and sell for many reasons, like a guy who sells and then the stock goes up. Maybe he bought a new boat or bought another stock that went up even more.

With the stock market in limbo this makes for a good read, i’ll post it on twitter now for the masses!

Take some time off,then let yourself get unstressed. Go fishing, golfing, play pool, do something else that will let you have fun and take your mind off the markets. There are other things in this world then money.

I often here it quoted that a person who times the market has to be right twice, and by a lot of people that I think are super smart, but that simply isn’t true. You need to be right originally… like your friend, before the market goes down. After that, being right the 2nd time is easy. Buy back before the market overakes your selling point plus commissions and you have done better than you would by sitting still. You may need courage to buy back in when you think the market may go down more, but you don’t need to be “right” again.

Best advice is to not look at your stocks for 1 year.

When Investing in Stocks, Your Job Is to Buy Profits

Some Tips for New Investors Who Want to Invest in Stocks

When you go shopping for school supplies, you buy notebooks and pens. When you go shopping for groceries, you buy fruits, vegetables, milk, bread, and cheese. When you go shopping for clothes, you buy shirts and pants. When you go shopping for investments, your job is to buy profits. This is true whether you are investing in stocks, investing in bonds, investing in real estate, or any other asset. Your job is to buy profits.

Beyond that, there are a few rules you must follow to be successful in your investments over the long-term, just like the millionaire dairy farmer near Kansas City, or Anne Scheiber, the IRS agent who turned $5,000 into $22 million, or Grace Groner, the secretary who gave away $7 million. Many new investors have no idea that 1 out of every 25 people in the United States is a millionaire. They have this illusion that financial riches always mean a Bentley, private jet, and trips to Saks when those folks represent a minority of the rich. Most financially successful people live in ordinary towns, drive ordinary cars, and outwardly live ordinary lives. The difference is, they invested their money wisely and now rank among the capitalist class.

1. Stick to What You Know

First, because you are buying profits, you need to focus on owning assets that you understand. If you owned a toll bridge, it’s easy to see that your profit is going to come from people going over your bridge in exchange for paying tolls. If you own a coffee shop, it’s easy to see that your profits come from selling coffee. If you don’t understand computers, how can you tell how a computer company is making its money? If you don’t understand aerospace defense, how can you properly evaluate the future earning power of the business? Use Warren Buffett’s tool: KISS, or Keep It Simple, Stupid!

Stick to what you know and take advantage of your unique knowledge. A construction worker probably has an advantage when evaluating construction companies over a banker. A banker probably has an advantage when evaluating bank stocks over a grocery store manager. A grocery store manager probably has an advantage when evaluating food stocks over a construction worker.

2. Pay a Fair Price

Nothing matters as much as the price you pay for your investment. If your job is to buy profits, the lower the price you pay, the higher your return. That is, if you are buying $1 in profit, your return will be 10% if you pay $10. Your return will be 5% if you pay $20. The price you pay is paramount to your results. Never forget that. It is the heart, the very secret, of those who are successful at investing in stocks.

3. Always Build in a Margin of Safety

A margin of safety is a buffer you build into the price you pay for a stock to protect yourself on the downside. If a company is healthy and you think it is worth $15 per share, you might want to only buy it if trades at $11 per share on the stock exchange. Just like an engineer builds a 15-ton bridge to withstand 20 or 30 tons as a margin of safety, only buying stocks for less than they are worth can provide the potential for a pleasant upside over the years. In the event of a market crash, it can help mitigate your losses as the underlying dividends and earning power of the business carry you through until more prosperous times.

4. There Will Be Years a Stock Is Down 40% to 50% or More

Lets look at the example of the 20-year review of Colgate-Palmolive. Now, a 20-year review of Procter & Gamble. Then Hershey Foods. Then McDonald’s. A pattern emerged. Good investments over the past two decades went virtually unnoticed by Wall Street, chugging along at a decent, but not exciting pace, as earnings and dividends continued to rise regularly. In almost all cases, these stocks had a few years in there where they lost 50% of their market value.

Those kinds of fluctuations shouldn’t matter for a true investor. If they cause you emotional turmoil, you don’t know what you are doing. In the wisdom of Benjamin Graham, stock prices are there for you to ignore or take advantage of based on what is best for you. They are not there to inform you of what a company’s intrinsic value is. That is your job to calculate.

How Selling Stocks Affects Your Taxes

Selling stocks will have consequences for your tax bill. If you netted a capital gain—because your stock transaction or transactions resulted in your making a profit—you will owe capital gains tax. If you netted a capital loss, you might be able to use the loss to reduce your income for the year. You might also carry the loss forward to the next tax year to offset any capital gain you may make then. 

Capital Gain Definition

Subtract the amount you paid for the shares from the amount you sold them for. The difference is your capital gain.

Capital gains don’t just apply to stocks. You can earn a capital gain on pretty much any asset you sell for more than you paid for it. However, in many cases, you won’t have to pay capital gains tax on a profit from a home sale.

Short-Term vs. Long-Term Capital Gains

If you owned the stock for less than a year before you sold it, it’s considered a short-term capital gain and you will be taxed on it at the same rate as your income. So the short-term gain tax rate corresponds to your income tax rate for your bracket.

If you owned the stock for more than a year, it’s considered a long-term capital gain, and you are taxed at a lower rate than your income. However, the long-term capital gain rate is determined by your income bracket. Those in the 10% and 15% brackets pay 0% on capital gains; those in the 25% and 35% brackets pay 15%; and those in the 39.6% tax bracket pay 20%. 

If you didn’t sell any stocks in the current tax year, you won’t pay capital gains tax but you may still have to pay tax on dividend income from stocks you own.

A Capital Loss

If you sold stocks for less than you paid to buy them, you have a capital loss. You can use capital losses to help offset capital gains. You must first use them against the same type of gain: So if you had a short-term capital loss, you must first use it against a short-term capital gain. Then you may use it against a long-term capital gain.

You can also claim a capital loss on your taxes to subtract as much as $3,000 off your taxable income for that year. Or you can carry forward a loss of as much as $3,000 to the following tax year to help offset a future capital gain. 

Sometimes, it’s wise to intentionally take a capital loss on an investment to help offset a large capital gain during that same year. This strategy is known as tax-loss harvesting. 

It’s usually not a good idea to offset long-term gains with short-term losses because those gains are taxed at a lower rate. You would probably be better off using the gains to offset income or carrying them forward.

A Prohibited Wash Sale

The Internal Revenue Service will not allow you to buy the same or, for all intents and purposes, identical securities either 30 days before or 30 days after you sold them to harvest a capital tax loss. The IRS will prohibit you from using that loss on your taxes because it considers the sale to have been a wash sale that was done only to save on your taxes. 

Preparing for Your Tax Bill

When you sell stocks for a profit, it is important to set aside the money you will need to cover your tax bill. Keep in mind that your tax bracket may go up because of your stock market profits: Capital gains are included in your adjusted gross income for tax purposes. 

Seeking an Accountant’s Help

If you are concerned about your tax situation and how much you will owe this tax season, you may want to consider hiring an accountant. An accountant can not only help you determine the best way to lower your tax bill; they can also help you figure out what your expected tax bill might be, so you can better plan financially.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Profit-Taking

What Is Profit-Taking?

Profit-taking is the act of selling a security in order to lock in gains after it has risen appreciably. While the process benefits the investor taking the profits, it can hurt other investors by sending shares of their investment lower, without notice.

Profit-taking can affect an individual stock, a specific sector, or the broad financial market. If there is an unexpected decline in a stock or equity index that has been rising, with no news or external events to support a selloff, it may be attributed to many investors taking profits.

Key Takeaways

  • With profit-taking, an investor cashes out some gains in a security that has rallied since the time of purchase.
  • Profit-taking benefits the investor taking the profits but can hurt an investor who doesn’t sell, as it pushes the price of the stock lower, at least in the short-term.
  • Profit-taking can be triggered by a stock-specific catalyst, such as a better-than-expected quarterly report or an analyst upgrade.
  • Profit-taking can also hit a broad sector or the overall market; in this case, it might be triggered by a bigger event, like a positive economic report or a change in Federal Reserve monetary policy.

Understanding Profit Taking

While profit-taking can affect any security that has advanced (e.g., stocks, bonds, mutual funds, and/or exchange-traded funds), people use the term most commonly in relation to stocks and equity indices.

A specific catalyst often triggers profit-taking, such as a stock moving above a specific price target; however, profit-taking may also occur simply because the price of a security has risen sharply in a short period of time. A catalyst that frequently triggers profit-taking in a stock is the quarterly or annual earnings report (SEC Forms 10-Q or 10-K, respectively). This is one reason why a stock may be more volatile in the weeks surrounding the period when it reports results.

If a stock has gained significantly, traders and investors may take profits even before the company reports earnings in order to lock in gains rather than risk profits dissipating if the earnings report disappoints. Investors may also take profits after earnings are reported to prevent further declines (e.g., if the company has missed expectations on earnings per share, revenue growth, margins, or guidance).

Taking Profits in a Specific Sector

Profit-taking in a specific sector—even against the backdrop of a strong bull market—could be triggered by an event specific to that sector. For example, a bellwether stock could report unexpectedly weak earnings in an otherwise hot sector, which could subsequently trigger profit-taking across the entire sector, due to fear. If a promising tech company had a poor initial public offering (IPO), investors might be keen to exit the sector overall.

If the profit taking is one-time event-driven—such as in response to a profit report—the overall direction of the stock is unlikely to change long-term, but if the profit-taking is in response to a bigger issue (such as worries about economic policy or other macro issues) longer-term stock weakness could be a risk.

Broad Market Profit-Taking

Profit-taking in the broad market is usually a result of economic data, such as a weak U.S. payrolls number or a macroeconomic concern (such as concerns over high levels of debt or currency turmoil). In addition, systematic profit-taking could occur due to geopolitical reasons, such as war or acts of terrorism.

It is important to note that profit-taking is typically a short-term phenomenon. The stock or equity index may resume its advance once profit-taking has run its course. Yet a concerted bout of profit-taking that knocks a stock or index down by several percentage points could signal a fundamental change in investor sentiment and portend additional declines to come.

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