Investors often hate sending money to the government, so some people go to great lengths to minimize the taxes they pay. Tax-loss strategies, or the selling of investments to claim losses, are one popular way investors reduce the taxes they owe. These strategies can improve the after-tax return of an investment portfolio. But unless they are executed optimally, they may cause investors to lose out on significantly better investment returns.
When large numbers of investors try to do the same thing at the same time, trades become decidedly less profitable. In fact, one could say that the “patron saint” of Wall Street is the lemming: running with the crowd may work well for a while, but doing so at the wrong time can be extremely costly. Tax-loss sales typically concentrate on investments that have sizable losses, which often means that these sales focus on a relatively small number of securities within the public markets. When a large number of owners sell at the same time it can put significant selling pressure on those issues. And because most investors tend to execute tax-loss sales in the last month or two of the year, that selling can become very concentrated. Worse still, the prices of shares that have large losses are typically already under pressure for fundamental reasons. For struggling securities, a spike of tax selling pressure has the potential to overwhelm the issue’s buying support, sending prices lower still.
Once the selling pressure ends, shares that become extremely oversold have an opportunity to bounce back. That bounce can be substantial. Academic studies have shown that many of the worst-performing securities at the end of one year tend to be among the best-performing securities in the first quarter of the following year. Ironically, therefore, the most attractive securities for tax-loss selling may also be the investments that are most likely to generate strong gains early in the next year.
To make matters worse, the best opportunity to buy some good long-term investments may also come as tax-loss selling peaks. Sometimes falling prices indicate a major problem with the investment, and investors are well advised to eliminate the holding. But the crowd is not always right. Even great long-term investments can fall out of favor with investors over extended periods of time, allowing those shares to become cheap relative to their potential long-term return. Lesser companies may not have the same long-term growth potential, but when they fall out of favor they can become extremely cheap. As securities near the end of one of these price declines, they may offer large tax-loss opportunities as they prepare to turn up again. For those securities, tax-loss selling has the potential to make a great long-term purchase even cheaper. When that happens, the normal bounce off the tax-selling lows can turn into a much longer period of strong performance. Bottom line: investors who take tax losses should be very careful to understand the fundamentals of their investment and try to determine whether their “losing” investment may be close to a major reversal.
So how can investors ensure their tax-reduction technique will be effective? Most importantly, they should avoid taking tax losses when most investors may be selling heavily. Most people tend to take losses in the fourth quarter, particularly in November or December. By simply avoiding any tax-loss sales in the last three months of the year, investors stand a reduced chance of selling as part of a large crowd. Losses recognized earlier in the year still reduce taxes, even if the savings are delayed to the next tax year. Those who feel compelled to take losses late in the year should at least try to sell early enough to repurchase the shares before year-end. While repurchases made late in the year may not offer the best possible prices, investors who repurchase before the year ends should at least benefit from whatever bounce occurs after the first of the year.
The best strategy is probably to buy during the tax-loss stampede, and sell after the tax loss has been established. Investors who “double up” on the number of shares they own may have an opportunity to establish new tax lots at extremely attractive prices. If they do not have enough cash to double holdings of a security, investors may be able to sell one tax-loss position to fund the amount needed to double-up on another holding. Note, however, that the “wash sale” rules will prevent recognition of the loss if a substantially identical security is purchased 30 days before or after the “loss” sale. Since there are complex rules regarding wash sales, investors should carefully review any tax-loss strategy with their tax advisor.
Investors can always hold a position for a longer time if they can afford the extra risk of the larger position and think it will be beneficial to do so. Normally, bounces that occur in tax-loss securities can last into February or March. When securities that were sold heavily during the tax-loss season outperform in January, investors should consider simply letting doubled positions run until the relative strength wanes. When it comes time to sell the original shares, investors may find they no longer have a loss.
When done properly, tax-reduction strategies can contribute solidly to improved after-tax investment gains. To avoid the pitfalls, however, investors need to carefully analyze their investments, and then use strategies that avoid getting themselves caught up in a crowd. Even better, investors can design strategies that capitalize on the very crowd behavior that often erodes the advantage of tax-loss selling. If we were to reduce it to a simple rule: from March through September it should be safe to sell first, but from October through February investors should “double up” first. Certainly, recognizing losses to reduce taxes can feel really good, but limiting taxes by improving after-tax returns can feel even better.