I won’t be writing my strategy thoughts for 2014 for a few weeks. However, it’s not too early for all of us to be thinking seriously about yearend tax selling, both as a market phenomenon and as a part of our personal portfolio management.
A disclaimer before I begin: I’m an investor, not a CPA. To get all the ins and outs of the capital gains tax rules, read the appropriate IRS or other tax authority publications.
why it happens
For most taxable investors in the US and mo,st other areas I’m aware of, the tax year ends with the calendar year on December 31st. (One major exception is mutual funds and ETFs. Their tax years generally end on October 31st–giving them time to close their books and make required distributions to their customers–who must pay tax on these receipts–before 12/31).
Investment gains are taxable once they’re “realized,” i.e., once the investment is sold. But tax is due only on the net gain–that is, after subtracting any realized investment losses–not the gross amount.
In an ideal world, we’d all be doing tax planning constantly. The reality is different. Professionals believe (correctly, in my view) that taxes aren’t the most important elements of portfolio construction, so sometimes, in my attention, they pay shockingly little attention. The rest of us just wait around until the end of the tax year approaches.
For taxable professionals, like insurance companies or banks, who hold “balanced” portfolios of several asset classes (stocks, bonds, alternatives), they’ll try to match sales of, say, money-losing bonds and money-making stocks so that the net effect is zero taxable income.
Or it may be that guidelines, either internal or regulatory, require them to prune large winning bets. In that case, they’ll scour the rest of the portfolio for anything with a loss attached to it and heave that overboard–just to knock down the tax bill.
This all occurs in the six-week period from early November to mid-December. Clunkers may be sold more aggressively but there’s also downward pressure on winners as well.
For individuals, the main focus of selling tends to be small-cap names that have performed poorly. They tend not to be sold with a very light touch. Instead, individuals typically dump them out without much/any regard for price–just to get rid of them. This sets the stage for the “January effect” as these beaten up stocks rebound after the first of the new year.
If the advent of tax season isn’t the reason for doing some serious thinking about what positions we want to take into 2014, it can at least be the occasion for doing so. For example, serial clunkers in our portfolios tend to find ways to make our eyes skip over them when we examine our holdings. It’s much harder for them to hide when we’re specifically looking for red ink to make use of
Similarly, we all love our big winners. But we also have to .remember that at some point the risk of holding a (for us) humongous position outweighs the possible future gains. Yearend is a good time to consider whether to trim. Don’t be like a hapless acquaintance during the internet bubble who rode JDS Uniphase from $ 3 to $1000 (a position of $100,000 to $30 million) …and back down again. Think Mark Cuban instead.
A more aggressive tactic would be to shop around for rebound candidates among this year’s big losers. They may be pushed down by, say, another 10% before the year is out as holders shove them out the door to take tax losses. This is not my style, so I have no words of advice, other than that you better do your homework before taking the plunge.
One more point: You can sell a position that’s deep in the red to recognize the loss and then buy it back. But the IRS says you have to wait 30 days before the buyback to be able to take the loss.
I’m not a fan of the tactic, although some people may be able to do this successfully. For me, it would be perpetuating the delusion that I haven’t made a mistake.