Volatility has returned to financial markets this year and for investors focused on the long-term, this is good news. Market volatility provides two opportunities to add value to portfolios.
One way to benefit from market turmoil is to rebalance your portfolio back to its target asset mix by buying assets which have dropped in price. Following disciplined rebalancing not only maintains the desired risk level of your portfolio, it also eliminates the emotional hesitation to sell what has performed well and buy what has gone down.
Not all losses are bad
No one likes to lose. In fact, behavioral economic research studies have found that we will go to great lengths to avoid taking a financial loss. Counter to our instincts, however, sometimes losses can be good. Specifically for portfolios subject to income and capital gains taxes, there may be a tax advantage to realizing a loss. The tax code permits realized losses to offset gains and, to a limited extent, income. For tax payers in the 22% marginal bracket and above, a loss taken has value since it saves the taxes due on a commensurate level of capital gains. As the saying goes, “a penny saved, is a penny earned.”
How to turn a loss into a gain
The well-established technique is to realize the loss and at the same time buy a different investment with similar, but not identical, characteristics. If it is identical, the Internal Revenue Service will not permit you to realize the loss. This process is often referred to as “tax loss harvesting” and works well when markets are sufficiently volatile to have assets with losses.
Tax loss harvesting, properly done, creates value. For example, $10,000 of realized losses, if offset against long term capital gains taxed at 15%, saves $1,500 in taxes. Transaction costs may reduce the savings to $1,400.
The devil is in the details
There are three details which require care in order to capture the tax benefits, net of costs. For HTG clients, these are part of our service.
- Must find a suitable substitute. When markets are volatile, don’t risk being out of the market. Some of the worst drops are quickly followed by some of the best positive returns. The best approach is to apply statistical tests to confirm that the same market factors drive the original and the subsequent investments in the same way. This will permit the tax loss to be realized without materially damaging the overall design of the portfolio.
- Keep track of purchase, sale and dividend reinvestment dates. Losses cannot be realized for tax purposes if the same fund is purchased and sold within 31 days of each other. In other words, after the sale, an investor may not repurchase it for at least a month. Any time after that period, the original fund can be bought. Likewise, if you are reinvesting dividends, you will not be able to realize the entire loss for tax purposes within 31 days before or after the reinvestment date.
- Maintain the overall portfolio’s investment strategy. Above, we noted that rebalancing adds value by buying low. Tax loss harvesting adds value by selling a loss, often in the same asset category to be bought for rebalancing. It is important to have the analytical tools to properly calculate the trades in order to both realize the loss and bring the overall portfolio back to its desired asset mix.
Nothing of value comes without effort
The above techniques take time and discipline to implement but the contribution to portfolio returns is worth the effort.
So, the next time there is a material drop in the markets, stay calm, think about the value of volatility and focus on your long-term goals.
If you are not sleeping well in these volatile times, you may be interested to read our blog Sleeping Well In Volatile Times.