Tax Loss Harvesting blah blah blah…

tax-loss-harvesting-investment-planning

You go to many of these online investing platforms and almost all of them tout the benefits of Tax-Loss Harvesting (TLH). So what is it and how much difference does it really make in your portfolio? TLH as an investment strategy has some value and it is something we do for our clients but having said that, we find that many of these sites make it out to be a much bigger deal than it truly is. They make it appear that they are the only ones who do this and nobody else in the world has figured it out. So what is it?

Most folks have a diversified portfolio. They own a variety of stocks and bonds and a variety of mutual funds and exchange-traded funds. When you have a highly diversified portfolio that is spread out among a wide variety of asset classes and market sectors, at any given moment, some of them are going to be rising in value more than others and some are going to be falling in value more than others. We know what happens when we sell an asset that has risen in value. We pay a capital gains tax on it. But if you have an asset that has fallen in value and you sell it, that’s a capital loss. So TLH is merely looking at your portfolio to see if you have lost any money in any of your investments and if so, selling those investments at a loss to capture the tax loss and then taking the money and moving to an alternate but similar investment so that you preserve the basic investment strategy. In other words, we wanted this money in this asset class and we bought a fund to do it but we are going to sell fund A to buy fund B giving us a tax loss on fund A which we can use for either straight-out tax deduction or to offset the gains that we might have incurred on the sale of another profitable asset. That’s it.

But our reasons for not getting too terribly excited about this is twofold –

  • If you are doing this whole investing thingy right, you are not supposed to be producing losses. And then to top it up, brag about it by giving it some technical sounding name. Are you supposed to get excited because we generated a lot of tax losses for you or are you going to get pissed? It is sort of like saying that I am a great driver and I can speed all I want but will make sure that I avoid the police when I speed. Well, you are not supposed to be speeding in the first place. So let’s not get too overly excited about the strategy here.
  • Second, if I own an investment and it has gone down in value and I am going to execute TLH, I am going to sell that investment to capture that loss and then go buy a different investment because the wash-sale rule can invalidate the entire transaction if I buy the original investment back within a specified time-frame. So I have to sell an asset that I bought because I liked it the best and then buy a replacement asset that I obviously did not buy the first time around but now am stuck buying it the second time around in order to execute the TLH. Which means maybe I am ending up with an inferior portfolio compared to the one I originally wanted and obtained. So then maybe, not selling at a loss is the better thing to do. Instead what I should be doing is buying more of it while it’s down simply because when it recovers, I will have more of it and my recovery will be faster and my ultimate long-term profits will be higher.

And that my friend is what we call strategic rebalancing which we believe is of greater value to a client in the long run than merely TLH. Because when we are engaging in strategic rebalancing, we are basically saying that instead of selling the asset that is low, maybe we ought to be buying the asset that’s low. And in that context, we believe that this produces results for the client that are better in the long-run even though they might not be ideal in the short-run from the tax management perspective. Investing isn’t just about minimizes taxes. Investing is about maximizing wealth.

So that takes us to the question at hand – how much difference does it really make in a portfolio from year to year? How much extra return will you get by implementing TLH? One thing is certain, the more losses you’ve got, the bigger the benefit there is. You realize the inherent absurdity of that statement, right? So like we said, many of these sites promoting this strategy or that technique is mere marketing without a lot of substance. And they market like hell and you think wow, this is something new, something you have never heard of. But maybe the reason you have never heard of this before is because the rest of us who have been in this business think that maybe this is not something you want to brag about.

And that is all it.

Happy Investing.

Image credit – Mark Gulm, Flickr