The Best Trade You Can Make in November

This article published with permission from InvestmentU.com.

In December 1996, I sold some shares of Best Buy to offset gains elsewhere in my portfolio.

I still consider it the most boneheaded investment move I ever made. A year later, the stock was up more than five-fold. A few years further on, it was up more than 30-fold.

The worst part is that I didn’t dislike the business prospects for Best Buy at the time — quite the contrary, in fact. I sold it only because I had substantial capital gains and was cleaning out my portfolio to offset them.

I don’t always do that anymore. And you shouldn’t necessarily, either. Despite what your tax advisor may tell you, you should never sell an investment for tax reasons alone. Nor do you have to.

Here’s why…

The IRS allows you to offset realized gains with realized losses each calendar year. However, if you do, you must wait at least 30 days before buying the same shares back. (Otherwise you run afoul of the wash-sale rule.)

The January effect

Offsetting gains at the end of the year is often a sensible move. Most stocks aren’t appreciably higher 30 days later. And if you still like them, you can buy them back then.

However, there is a risk, and it’s called the “January effect.” The first month of the year is traditionally a strong one for the market. A lot of pension and IRA money gets invested early each year. Plus, there’s often a rebound from the tax-loss selling that goes on each December.

If a stock you own soars in January, there’s a natural reluctance to buy it back. The temptation is to wait until it comes back down. But what if it doesn’t? You’ve taken a limited loss but sold an investment with unlimited upside potential.

There’s a way around this problem, and you can take advantage of it — but only if you’re willing to move this month…

Doubling down

In late November each year, I look at my entire portfolio for any companies that are trading below my entry price but NOT near my trailing stops. If I still like a stock, I often make the decision to double-down on it for 30 days.

Why? Because I can sell the original shares at the end of December for a tax loss. And if the stock rallies in January, it’s not a problem. After all, thanks to my purchase in November, I own the same number of shares as I bought originally.

What if you don’t have the cash to double down on your position? Use margin. Again, I’m recommending this only for a 30-day period. Your margin interest charge will be minimal.

The risk, of course, is that your shares will be worth less in late December and you will have a paper loss on the second purchase.

However, just the opposite may happen. Remember, the January effect is often preceded by the Santa Claus rally, the tendency of the stock market to do well in the second half of December. As a result, you could end up with a smaller loss in your original shares and a paper gain on your second purchase.

(The Santa Claus rally is never certain, of course, and another reason why you should only add to those companies whose earnings prospects remain strong.)

Bear in mind, when selling for tax purposes, the IRS requires that you buy those identical shares AT LEAST 30 days before you sell the others. So if you want to use this strategy for 2012, you must act this month.

If we have the traditional mid-December to early February rally, you’ll thank me. And then perhaps again on April 15.

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.