This newbie mistake could cost you thousands | Smart Change: Personal Finance
Stock market corrections – defined by drops between 10% and 20% in major indexes – are inevitable in the stock market. In fact, it tends to happen at least once every two years on average. If you are an investor, you will save yourself some stress by coming to terms with this fact. The one thing you definitely want to avoid is panic selling. Not only can it be expensive right now, but it could also cost you a lot of money in the future.
Let time work its magic
Compound interest is one of the greatest investment concepts. Albert Einstein even called it the “eighth wonder of the world.” Compound interest occurs when the money you earn from your investments starts to make the same money. But for compound interest to really work its magic, it takes time. If you made a one-time investment of $10,000 in an asset that returned 10% annually, you would have raised $108,000 in 25 years.
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When things go wrong in the stock market and prices start to fall, some people panic and sell their holdings, because they are afraid of losing more money. For long-term investors, panic selling is one of the last things you want to do, because it removes the power of compound interest.
Imagine that for the past 10 years, you’ve been contributing $6,000 annually to a Roth IRA (maximum for people under 50), and those holdings have returned 10% annually. In those 10 years, you’ve raised over $105,000, even though you personally only contributed $60,000. No matter what happens in the market, cashing in $105,000 will likely be a mistake.
If you keep your contributions going for another 10 years, you’ll invest an additional $60,000, but the total value of your account will be more than $378,000 at the end of the second decade (assuming the same 10% rate of return). Had you withdrawn from the market, you would have interrupted the powerful effect of compound interest on your portfolio.
Even if you sell your investment for only one year, say, year 16, before reinvesting it for the rest of the decade, your holdings will only be $346,000. In other words, even with all annual contributions of $6,000 still being made, that one-year vacation reduced your return by more than $30,000.
Don’t forget Uncle Sam
Another reason you might want to avoid panic selling during stock market corrections or downturns is that it can be more expensive than you imagine once you factor in the tax consequences. For a standard brokerage account, if you have held investments for less than one year, the proceeds from the sale are taxed at your ordinary income tax rate. For single files in 2022, the parentheses are:
|income group||tax rate|
|0 dollars to 10,275 dollars||10%|
|$10,275 to $41,775||12%|
|$41,775 to $89,075||22%|
|$89,075 to $170,050||24%|
|$170,050 to $215,950||32%|
|$215,950 to $539,900||35%|
|$539,900 or more||37%|
If you have held the investments for a year or more, you benefit from the capital gains rate:
|income group||Long-term capital gains tax rate|
|0 dollars to 40,400 dollars||0%|
|40401 USD to 445.850 USD||15th%|
|$445,851 or more||20%|
Although the capital gains rate is more favorable than the usual income tax rate, money is still owed. If you’re selling in response to short-term fluctuations, you’ll need to think about how much the taxes will cost you as well. Paying 15% on $100,000 in capital gains is not only $15,000 that you’ll owe from your next tax bill, but it’s also $15,000 you won’t have the opportunity to earn interest on.
Keep your eyes on the price
Long-term investors should focus on this: the long-term. If your portfolio is taking a hit due to a stock market correction, flip your mindset and see it as an opportunity rather than something to panic. Warren Buffett put everything into perspective when he said, “Be afraid when others are greedy, and be greedy when others are afraid.” Your long-term goals should not change due to short-term trends in the market. Stay on track and keep your eyes on the prize.
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