Buy and hold
You have decided to buy and hold a portfolio of 10 stocks in a $100,000 portfolio. After four months, the total value of the portfolio has risen to $103,000. One stock, Bank of America (BAC), has dropped 30% to just $7,000, but most of the other holdings have gains.
Given your belief that BAC will bounce back from its loss, you hold onto it. Six months later, the portfolio value is $110,000. The BAC has recovered all of its loss and has a value of $11,000.
Replace a losing stock with a similar stock
Rather than holding onto the BAC after it had dropped, assume that you sold it to realize a $3,000 short-term loss. With the proceeds from the sale, you purchased $7,000 of Wells Fargo (WFC). Replacing the BAC with a similar financial stock helped to maintain the portfolio diversification.
As before, the portfolio value rose to $110,000 six months later. At that point, the WFC position had also risen to a value of $11,000.
Tax loss harvesting
Capital gains tax works in reverse for a capital loss: for the benefit of the taxpayer. You can exclude from your taxable income up to $3,000 in capital losses. If you are subject to the top 35% marginal tax rate, this exclusion lowers your tax by $1,050.
By proactively selling a stock and harvesting a loss, you gained a tax savings. The simple buy and hold approach left $1,050 on the table. If you chose to invest the savings, tax harvesting would have raised your portfolio value to $112,050.