Long term investment is a fine way of building wealth over time. We must remember that we cannot use this wealth unless we liquidate the investment, and convert it into cash. Many times, we are stuck with wrong investment choices and do not liquidate because of fear of converting notional loss to real loss. Sometimes, we keep stocks for longer period even when the stock has run up to its peak and has given us expected returns. The reason is many investors do not know when to sell their investments.
Almost all the people who invested in 2006-2008 timeframe are still holding onto their investment despite getting no returns in last 4 years (in some cases, negative returns). A majority of investors follow the simple idea of turning their loss making investment into long term investment while liquidating their profit making investment at marginal gains.
Long term investment provides good returns only when investors invest in the times of low market and let it be there for few years. Unfortunately, many investors do not spend time and do not have patience to wait for such a long time. Most of the investors would like to make short term profits and keep churning portfolio to get immediate returns. However, to make profit in short term investment, we should know the taxation and other policies to make the most of our selling of investment.
Short term loss can reduce your tax liabilities
If you make losses on investment in the short term, the loss can be used to offset your tax liabilities on your short term gains. You can use this in the following ways.
Offset the gains to reduce taxes – Suppose you have made short term losses of Rs 75,000 in the financial year FY2011. This loss can be used to offset your short term gain in the year FY2012. For example, if you have made short term profit of Rs. 2 lakhs in FY2012. You can offset Rs 75,000 from it to reduce your tax liabilities. Your tax will be calculated on Rs 1.25 lakhs and not on 2 lakhs.
Use your temporary loss making investment to reduce taxes – Suppose you have bought fundamentally strong shares which are facing temporary hurdles. Currently, these strong stocks are quoting at a loss of about Rs 75,000. You may not like to sell them at the loss because you know that this is going to fetch you good returns in future. Suppose that you have made Rs 2 lakhs as short term gain in a financial year. In this case, you can liquidate your sold stocks and book the loss of Rs 75,000. This loss can be used to offset your tax liability. You will essentially pay tax on Rs 1.25 lakhs. Once you sell your strong stocks, you can again buy it next day. There will not be much change in the price in a day.
Tax policies on short term and long term can be used profitably
Long term is defined as more than a year while short term is less than a year. If investors sell their investments after a year from buying, there will be no capital gain tax on the profit. If they sell it within a year, there will be tax on the gains. Investors must see if it makes sense to hold the stocks for few more months or weeks so that the holding period stretches to beyond a year. This depends also on what is your view on the stock as well as nature of the stock. A defensive stock can be held for few more months or weeks without much change in the price. A volatile stock can fluctuate wildly in a few months or weeks. In either case, when investors cannot guess the price movement, it is better to keep the stocks for more than a year and then liquidate.
Bonus shares can be used to enhance gains
Bonus shares work in a different way. When companies issue bonus shares, the price of extra shares is assumed to be zero. Suppose Reliance issues bonus shares in 1:1 ratio. It means everyone who owns a share of Reliance will get another share. If the price of Reliance share is Rs 750, the price should ideally reduce to half because of issuing a new share. Let’s assume that the price goes down to Rs 400. This means an investor that owned 100 shares of Reliance will now own 200 shares of Reliance.
Now if the investor sells 100 shares of Reliance in the market at Rs 400 a share, he will be incurring a loss of Rs 35,000 (Rs (750 – 400) * 100). This loss can be adjusted to any short term gains to reduce tax liability. Even after selling 100 shares of Reliance, the investor still has 100 shares that were issued as part of the bonus. The purchase price of remaining shares will be considered 0 for tax calculation when these remaining shares are sold.
Finally, sell your bad investment and keep your good ones. Do not hope that your bad investments will turn into good because of sheer luck. In the world of investment, taking bad decision is very common. All you have to make sure is that you take more right decision that wrong ones.