Losses Can Be Good

Sell your losers to boost net returns and reduce your capital gains tax liability

Tax loss harvesting should go in coordination with rebalancing your portfolio. The idea is very simple – sell the investments you’re currently losing money on to offset your current tax liability or future tax liability. The taxes we’re talking about here are capital gains taxes, taxes you pay on profits whenever you sell an investment. By selling an investment at a loss, the IRS allows you a loss benefit that is subtracted from gains on other investments you’ve sold, reducing (and possibly eliminating) your taxable profits.

Taxes take away from your net return and so tax loss harvesting optimizes your portfolio to increase your portfolio’s net return. Wealthfront (an automated portfolio manager) did a study to show that tax loss harvesting increased performance by 3.12% to 6.24% for their clients in 2018, depending on the client’s tax rate bracket. This is going to vary from year to year as we need losses and volatility to impact the portfolio (which we have a lot of this year in 2020), but this shows that tax loss harvesting will materially benefit your portfolio.

When you rebalance your portfolio, always sell the positions (you may have to get tax-lot specific) with an unrealized loss and buy back into another position that gets your portfolio allocation back to target. Watch out for wash-sale rules. Basically, you can’t buy back into the exact same position that you’re harvesting. You have to wait at least 30 days to do so or you can buy something else right away that has similar characteristics.

Behavioral finance studies suggest that people tend to hold on to their losers because it’s hard to admit and move on from a bad pick. This is called the disposition effect. I believe passive, globally diversified investors don’t have that issue because we’re focused on a target allocation defined by our long term financial goals and hold ETFs/mutual funds instead of individual positions we’ve bet on. This type of portfolio management strategy eliminates most of the emotional pitfalls of investing because we know that a diversified portfolio held long term will generate the expected returns. We know that a diversified portfolio has uncorrelated assets that move in different directions and that will lead to losses in some asset classes in the short run. Tax loss harvesting allows you to take advantage of that short term volatility while remaining invested in the asset class as a long term investor.

Another benefit of harvesting losses is that if you have more losses than gains to offset, you can also apply up to $3,000 of losses to reduce your ordinary tax liability (the tax you pay as a portion of your income).

In addition to rebalancing, tax loss harvesting is another to do item for periodic portfolio maintenance that all investors should be doing.

Compliance stuffs
Just remember, I’m not your financial advisor so the information may or may not best apply to your situation and you should get formal advice prior to doing anything. The information/data that is shared should be double checked by you and any conclusion that is driven based on past data is not to be interpreted as my advice for your future. I will do my best to only write what I think is true and right, but mistakes happen and we’re all learning together – this is meant to be a conversation.

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