When Life Gives You Lemons…
…you capture capital losses, of course.
In declining markets, the wish to do something is natural. After all, humans have evolved and thrived in part by being attentive to perceived risk and acting to mitigate threats. Ironically, however, doing nothing with your investments is often a wonderful demeanor, including when prices are falling. After all, should we really be selling assets when they are being marked down with sale pricing? John Bogle, founder and former CEO of Vanguard may have summarized this best: “Don’t do something; just stand there!”
However, there is one action which attentive investors can take with their taxable (non-retirement) investments while licking their investment wounds: tax loss harvesting. We regard this as an opportunity to save our clients money simply by monitoring conditions and capturing opportunities which they present.
The Summary
While we can’t administratively change the stock and bond markets’ direction, we can take steps to lower our tax bills for the year. How? Outside of retirement accounts, we pay taxes on the gains in our individual investments. In other words, we’re taxed on appreciation between what we pay for and sell our investments. This is called a capital gain, and it receives a favorable tax rate from the IRS compared to “ordinary income” from sources such as wages and interest. These gains can be significant in a rising market such as we’ve enjoyed for more than a decade. But – gains are triggered only when we sell investments. “Holding” appreciated investments generates no taxable event, as it’s called. What if we don’t want to sell in a falling market but still would like to give ourselves a tax favor? We sell the investments we’ve accumulated, thus “capturing” a taxable loss, and buy similar investments in their place in order to remain invested. Similar but not too similar. I’ll elaborate below.
The Details
In place of investments we’ve sold for our clients this week, we’ve bought for them exchange traded funds which are similar but “materially different.” We do this in order to both maintain their broad and balanced asset allocation and diversification as well as comply with IRS regulations that the investments we bought not exactly replicate those we’d sold. In each tax year, realized capital losses are netted against realized capital gains. In addition, you can use up to $3,000 in net realized capital losses against ordinary income. Any additional amount can be “carried forward” to net against future years’ realized capital gains.
Once the 31-day holding period for today’s purchases is met, we will look for opportunities to rebalance our clients’ non-retirement/taxable portfolios. This will allow us to recreate their original investment mix while accruing to them these tax benefits.
The result? Our clients remain invested according to their prescribed asset allocations, maintaining a consistent level of both participation in markets and risk. But they’ve gained something better still than Mr. Bogle’s advice to just stand there: they’ve reduced their 2022 tax bills.
Markets
On top of the stock and bond declines we’ve seen already this year, corporate earnings released this week have reflected higher fuel and wage costs, in particular, adding to investors’ concerns over the possibility of the economy slowing the point of a recession. On May 20, the S&P 500 slipped briefly into “bear market” territory, which is simply a term used to describe a decline of 20%. (The tech-heavy NASDAQ, meanwhile, is well below bear market territory, having fallen almost 30% from its November 2021 peak.) We have been intentional in positioning our portfolios to mitigate the imbalance in the overall market toward these well-known “growth” stocks by adding more undervalued, or “value,” stocks over the past couple of years. A recession, meanwhile, is an economic term describing two consecutive calendar quarters of shrinking production of a nation’s goods and services. Bear markets don’t necessarily result in recessions. And recessions don’t necessarily result in lower stock and bond prices. Markets are forward-looking economic indicators, meaning that changes in market valuations tend to precede changes in economic conditions. According to the investment management firm Invesco, between 1929 and the end of 2020 there have been 17 bear markets, 9 of which were accompanied by recessions. From these data is born what passes for humor in our financial circles, with Nobel Prize-winning economist Paul Samuleson famously saying that Wall Street had successfully predicted nine of the past five recessions.
The millions of new investors who began trading in the early days of the pandemic are now facing the realities of gravity. According to Todd Lowenstein, chief equity strategist of The Private Bank at Union Bank, “we’re going through a recalibration process and that’s a good thing. In the short run it will be painful, but sometimes you need short-term pain to recondition behavior.”
What can you do to enhance your pursuit of your long-term goals? Doing very little is often very wise. A couple of steps that can be quite beneficial are rebalancing and tax-loss harvesting. You can read more about them here:
Through this we remain true to our principles of discipline, perspective, patience, courage, and calmness. Our investments are expansive in their market coverage. They are carefully balanced, broadly between stocks and bonds, and within categories of each. They are among the very lowest cost and most tax-efficient vehicles available. Our ETF’s are always transparent and liquid. As Warren Buffett once said describing periods of market decline: “Only when the tide goes out do you discover who’s been swimming naked.” On behalf of those who place their faith in us, we remain committed to our demeanor of prudence.
