Recently I’ve seen a few studies and charts on Twitter that lend favor to Tax Efficient Investing. These are portfolios where each holding is designed to be held for more than one year. This stragegy allows them to qualify for reduced taxes as a Long Term Capital Gain. The articles I’ve seen generally advocated by financial planners and advisors who see Tax Efficient Investing as their way to add value or have an edge for the clients of their practice. But not once have I seen a credible article playing the role of Devil’s Advocate for Tax Efficient Portfolios. Today the Dow Jones Index was down 660 points at mid-day. It would seem apropos to highlight a few of the disadvantages of Tax Efficient Investing.
The points I will make are from the perspective of a Growth-oriented investment advisor whose primary investment vehicles are stocks, ETF’s and ETN’s. Municipal bonds are a different animal altogether and not the subject of this blog post.
Are the lower taxes worth the losses?
The primary objective of Tax Efficient Investing is to own an investment for at least 12 months. Our primary objection to this strategy is prioritizing time of ownership over gains. Investment gains can disappear or be significantly reduced by the goal of hanging on for one year. For example, you buy a stock at $50 on January 1, 2017 and perhaps by April 2017 the stock is $65. But by January 2, 2018 the stock could be anywhere. A major sin of investing that you open yourself up to is not taking the gain in April. If the market goes into a sell-off where the stock goes back to $50 or below, your gain has been negated. It reminds me a bit of the game show “Let’s Make A Deal” with Monty Hall. Monty would offer a contestant a sure deal right off the bat, but with the caveat of “Would you be willing to give up the sure deal for whats behind Door 1”. It could be a brand new living room or dinette set (hey I watched it in the 1970’s). It could also be a rusting bucket of used auto parts. At that point Monty would offer the bizarrely dressed contestant the consolation prize of the home version of the game show. Cue sad trombone.
The stock could also have gone to $75 in good market as well, up 50%. If the stock continues to rise without any major setbacks, an experienced Trend Following methodology as well as a Tax Efficient investor would likely continue holding on to the stock. There is a primary difference between a Trend Following system – which we employ – versus a Tax Efficient strategy. We’d take a profit should the stock decline below important benchmarks. Declines below certain sell points raise the question of whether the stock is even in an uptrend. By the way, how hard it is to find a stock that can smoothly rise throughout the entire year? This means the company must produce 4 good earnings reports in a row and not sustain large pullback. 2017 was an easy year for Trend Followers. Even then almost 95% of the stocks we bought could not sustain 12 months of positive performance.
Are the drawdowns tolerable?
In point 1 I discuss a scenario of a single stock. But if Tax Efficiency is the goal along with long term Growth, you can now envision how volatile that portfolio would become. By not exerting proper risk controls, the portfolio would likely have longer and more significant drawdowns. Is that something you really want? Most investors, especially those who are new to investing cannot endure declines of 30% or more to their portfolios. This begs to ask: “Would you pay a bit more in taxes for less volatility?” In my experience which is based on client retention, the answer is “yes”. People hate losing money more than paying higher taxes.
What about lagging holdings?
Digging down deeper into portfolio management is the issue of what to do with lagging holdings. A lagging holding is the stock that you have had a gain on, but is now going nowhere. Our view is to sell laggards in a rising market. We don’t see the value of holding an investment unless its producing for you. A major advantage to this is to look for new potential winners. But the Tax Efficient portfolio may hang on to the stock till it clears the one-year hurdle. This is another factor contributing to underperforming portfolios.
To sum it up: Tax Efficient Investing can be a proper strategy for some investors but for most it isn’t. Investment methods must not just make financial sense. The methods must also be cognizant of the investor’s risk profile and emotional impact. One size does not fit all and every investment method has some inherent weaknesses. Most investors would probably feel more comfortable knowing the achilles heel of any strategy.