Opinion – Grain in Grain: The decision between selling an asset that has a profit or one that has a loss is not obvious

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Many times we need to make a redemption and we feel sorry to sell a position just because it presents a loss. The preference to sell a position at a profit seems almost obvious. But, this may just be a reflection of a behavioral bias. In fact, there are situations where preferring to sell the position at a loss may be the best choice.

Imagine an investor who intends to make a down payment on a property worth R$50,000 and has only two funds in his portfolio. The two funds are shares and both have the exact amount of R$ 50 thousand net of Income Tax (IR) for redemption.

While the investment in fund A has a loss of BRL 5 thousand, the investment in fund B has a profit of BRL 5 thousand.

Which of the two funds would you redeem?

I will explain the decision process.

The first reason for choosing is related to future potential.

It is not because a fund has fallen that it necessarily has a greater chance of devaluation. Also, just because it went up doesn’t mean it doesn’t have more potential for appreciation.

Therefore, it is necessary to analyze whether both have the same perspective of future returns or if either has greater potential for appreciation.

Your decision should be made as if you had the money in hand and had to choose between investing in one or the other.

Try to disregard that you already have the investment made. This way, you avoid falling into the trap of wanting to avoid making a loss, that is, assuming you made a mistake in the past.

Assuming that both have the same potential for future appreciation, we can move on to the second decision element.

The second element is related to IR. Note that in one of the funds you must pay IR and in the other you do not have to pay IR, as you have a loss.

Here’s a general rule, which like any general rule has its flaws, but it works for most cases.

Always prefer to redeem from that product that you pay less IR today, assuming all other characteristics are similar.

This means that if two products have the same future appreciation potential and a redemption is necessary, prefer to redeem the one that you pay less IR.

When looking at the above recommendation, the decision seems self-evident. But that’s not how most investors behave.

There are two reasons for this preference for deferring the IR payment.

First, if you redeem from fund A, which has a loss, you will be able to use this accumulated loss to deduct from a future profit when you need to redeem fund B. This benefit can be used automatically in most banks and brokers.

Second, if both have the same upside potential, if you keep fund B that has a profit, you’ll earn a return on an IR and get a higher value in the future. I explain below.

Income tax on equity funds is 15% of profit. Consider that in both applications the potential for appreciation is 10% in one month.

If you prefer to keep fund A with a loss of BRL 5,000, at the end of the month you will have the amount of BRL 55,000, after the 10% appreciation. As it has appreciated to the initial level, there is no IR to pay if it is redeemed. In other words, your net income tax for redemption at the end of the month will be BRL 55,000.

Let’s now assume the opposite situation, ie, he rescued the fund at a loss and kept fund B at a profit.

When you rescued fund A, you had a loss to compensate for R$ 5 thousand.

As fund B had a net redemption value of R$50 thousand and an accumulated profit of R$5 thousand, this means that the gross value of the position was R$50.75 thousand.

This occurs because when the IR rate of 15% is applied on R$ 5 thousand, the value is R$ 750.00. Thus, when the income tax is subtracted from the BRL 50.75 thousand, the net BRL 50 thousand remains.

When we apply the 10% appreciation on the value of R$ 50.75 thousand, we arrive at R$ 55,825.00. As you have already redeemed the value of the fund with IR before, you have an amount to offset.

Thus, you not only postponed the IR payment, but also gained appreciation on top of it.

The net amount to be redeemed would be BRL 55,085.0 (= 55,850.0 – 0.15 * (55,850.0 – 5,000 – 45,750)).

Therefore, you ended up with R$85 more if you preferred to redeem the fund at a loss earlier.

So, when redeeming, first consider the future potential for appreciation and then prioritize having a loss to write off rather than paying IR today.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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