When you invest in stocks, there will be ups and downs for your portfolio. There's also a strong chance you'll experience a stock market crash at some point. While there's no official definition for a market crash, the term is normally used when major stock indexes drop by over 10% in a short amount of time.
Stock market crashes are stressful, and many people aren't sure how to handle them. Some get so worried that they sell stocks to cut their losses. After all, when there's no telling how far the market will fall, selling may seem like the safest solution. At least if you sell, you avoid losing any more money.
That's a decision you could end up regretting later, because it's one of the biggest investing mistakes. To understand why, it's important to know exactly what will happen if you sell stocks during a market crash.
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You lock in your losses
When your stocks decrease in value, you might think that you've lost money. That's not entirely accurate. These are known as paper losses. If your $100 investment drops to $80, you have paper losses of $20. But it could be worth $85 next week, and $110 in a few months. Paper losses are impermanent, because stock prices fluctuate. You haven't actually lost money yet.
However, once you sell your stocks at a loss, you've locked in your losses. If you sell your $100 investment at $80, then you've officially taken a $20 loss.
The benefit is that by locking in your losses, you guarantee they won't get any worse. The problem is that a market crash is usually the worst time to sell stocks. You'll most likely be selling at a heavy loss, at a time when prices are at or near a low point.
You'll miss out when the stock market recovers
Every time the U.S. stock market has crashed, it has eventually recovered. It often takes a few years. For example, the S&P 500 (an index of 500 of the largest publicly traded companies on U.S. exchanges) took about two years to recover from the 2008 financial crisis. But this isn't always the case. When the stock market crashed in 2020 due to the COVID-19 pandemic, it recovered in just six months.
This doesn't mean the market is guaranteed to recover, but it's what has happened so far, and it's the most likely outcome. Here's how that impacts investors, depending on what they do with their stocks during the crash:
- Investors who held their stocks will see their portfolios recover.
- Investors who held their stocks and continued investing will do even better. They bought stocks while prices were down, which means they'll get larger returns.
- Investors who sold their stocks already locked in their losses, so their portfolios can't bounce back.
That's why investors who sell their stocks often regret it. It's disappointing enough to sell at a loss, and it's even worse when you see those stocks bounce back later.
Remember that just because your investments are down doesn't mean they're bad investments. In a stock market crash, most stocks lose value. If you believe a stock is a good long-term investment, then you should hang on to it and continue investing in it. A market crash is an opportunity to get a better deal on the stocks you like.
You can deduct your losses on your taxes
The advantage of selling stocks at a loss is that you can deduct these capital losses on your taxes. You're allowed to do this when your capital losses (the amount you lost that year on investments you sold) exceeds your capital gains (the amount you made that year on investments you sold). So, if you have a stock that you no longer believe is a sound investment, selling at a loss could be the best move.
You're allowed to deduct a maximum of $3,000 in capital losses from your total income for the year. If you lost more than $3,000, you can carry forward those additional losses and deduct them in future tax years. For example, if you have $9,000 in capital losses, you could deduct $3,000 per year for the next three years.
Tax benefits aren't worth selling a quality investment, though. Imagine if you were an early investor in Apple or Amazon, and you sold your shares at a loss just to save money on your taxes. It's also worth mentioning that you can't sell a stock at a loss, buy it back immediately, and then deduct the loss on your taxes. If you repurchase the same stock within 30 days of selling it, that's considered a "wash sale," and it can't be deducted from your income taxes.
LEARN MORE: A Complete Guide to Investing and Taxes
It's normal to want to avoid losing money, but this desire can backfire if you let it influence your investing decisions. The best approach is to figure out your investing strategy from the beginning, including what you're going to invest in, how much you'll invest, and how often. This way, you don't need to make impulsive decisions during a market crash. You can stick to the plan, continue investing, and wait for your portfolio to recover.
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