Every single year at about this time, the same stupid advice emanates from the personal finance press for one simple reason. The personal finance press is desperate…desperate we tell you to make themselves look smarter than you, to illustrate that they are cleverer than you to justify the subscription price they demand you pay them. To get you to subscribe, to get you to read, to get you to listen. They are going to say clever things designed to make you think that it will make you money and save you money. That premise, many a times is utter nonsense.
So here it is again. We predict at this time of the year that you will read this advice, you will hear this advice but you need to ignore it. And like clockwork, it shows up every year. In fact, Kiplinger in their recent edition was the first to offer this stupid advice but they will not be the last. And here it is: “Be careful if you buy a mutual fund late in the year”. If the fund pays a distribution (capital gains) after you purchase, you will have to pay a tax on that payout even though you were not around to enjoy the gains that the fund made over this year and years before. Okay true, but financially you are no better off regardless of the timing of your purchase. Let’s try to understand the issue so that we can help explain how astonishingly stupid this proposal is.
Mutual funds distribute capital gains even though as a shareholder, you did not sell any shares. That is because the fund manager sold appreciated shares inside the fund with taxes owed on those gains passed down to the fund shareholders. Here’s an example – say a fund trades at a Net Asset Value (NAV) of $10. If transactions within the fund resulted in it making a capital gains distribution of $2 a share, that $2 will be deducted from the NAV and paid to shareholders on a specified date. On that date, the fund’s share price will decline to $8.
But you know what, you haven’t lost any money. You still have $10 in total value – $8 in the fund’s NAV and $2 in your pocket which most likely would be reinvested back in the fund, buying you additional shares at the new lower price of $8. These additional shares compensate for the drop in the NAV and hence the total value of your account remains unchanged.
If by next year, the NAV climbs to $12 and you sell the fund shares, had you bought before the distribution date, you will pay tax on the difference between the sale price ($12) and the original purchase price ($10). But instead, you bought the shares after the distribution so you will pay a tax on the difference between the sale price ($12) and the post-distribution price ($8). By buying before the distribution date, you are in a way splitting your tax burden between two years instead of just one, potentially helping you lower your effective tax hit in a given year.
So Kiplinger’s advice on this is pure garbage. But here’s the irony. Not only are you holding off investing for no reason, you are also potentially missing out on profits by sitting on the sidelines. And that is the bigger issue we have with this advice. The longer-term trajectory of capital markets is up and waiting to invest is a fool’s errand, especially when you are saving for retirement many decades out. The personal finance press makes it look like this strategy makes a difference but it does not but it sure makes them appear cleverer.
But here’s a better option. Instead of sitting on the sidelines till the fund distributes capital gains, why not buy a fund that does not declare big distributions. What triggers distributions? Turnover ratio. What is turnover ratio of a fund? A typical mutual fund’s turnover ratio is about 100% which means that the fund sells everything it owns within a year and buys its replacement. You might be a long-term investor but you own an investment that is making too many short-term bets. So it’s real simple. Don’t pay attention to this nonsense advice from these media pundits who are trying to make themselves look cleverer by telling you how to avoid a capital gains distribution by sitting on the sidelines with your cash. Instead, invest now and capture the profits those businesses that make up that fund generate but invest in a vehicle that doesn’t trigger those distributions in the first place. That means investing in a fund that holds a collection of fantastic businesses for a long, long, long time. And then you are done. No turnover, no distribution, no complication.