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There are a lot of adages about investing that seem sensible but don’t always result in the most successful investment experience for the investor. One that has become a quasi-religion for investors is that if you want to make the most money over the long run, you need to buy and hold. A second commonly heard adage is to buy low and sell high. While these sayings are very intuitive and they might reinforce your beliefs about how you should invest, following them won’t always serve to maximize the returns in your portfolio. In fact, one of the more difficult concepts to understand is that you can often maximize your investment returns by limiting holding periods and selling for losses. How does selling for a loss help improve investment returns? The answer is: Because it reduces the future tax liabilities of the investment. What is important to calculate in an investment portfolio is not the actual dollar amount of the holdings but the actual amount of dollars retained after the gains are shared with the IRS. You need to maximize the amount of spendable dollars and you do this by reducing taxes. Tax authorities are in the business of making sure that when you have a profit, you share that with them. There is not much you can do about that. However, what you can do is make sure that when you have a loss that you also share that with the tax authorities. Buy and hold strategies advocated by the great majority of investors have grounding in two common themes. First, over long periods of time, the best place to earn good returns is in the equity markets. Second, you need to patiently hold these investments to earn those returns. While I fully believe in the first concept, I think the second one keeps investors from maximizing the returns generated from their monies. In fact, the hottest current topic in the field of portfolio management, other than investing in hedge funds, is efficient tax management. The major component of efficient tax management comes from harvesting tax losses whenever possible. Tax losses happen to be one of the few types of losses that are actually good to realize. You need to take advantage of them whenever you have the opportunity to do so in a cost-effective manner. It would have been very easy to generate unrealized losses in a portfolio over the last market cycle. In fact, with the recent declines, even the most broadly diversified portfolios have some amount of unrealized losses. Emerging markets, sub-prime lenders, and homebuilders are only a few sectors that have come under pressure lately. A buy and hold investor can wait for years to pass in order to recoup their investment, or they can earn some immediate measure of return by selling the holding for the tax loss. If a losing investment is sold, there is a capital loss that can be used to offset capital gains or carried forward to use in the future. This economic value can be realized only when you sell the position instead of holding it for the long run. One of the main reasons people don’t harvest losses is they are afraid that as soon as they sell their investment, it will turn around and go back up. They fear that this will occur before they have a chance to repurchase their holdings. There is a lag between when you can sell an asset, claim a tax loss, and repurchase it without triggering the wash sale rule. Generally, if you sell an investment at a loss, the wash sale rules states that you need to wait 30 days to repurchase it, or any substantially identical asset, or the tax loss will be disallowed. When you invest in individual securities, the wash sale rule often prevents the effective harvesting of tax losses. After making a sale, you need to take on market risk for 30 days as you wait to repurchase your security. If there is a substantial rise in price over this period it can easily erase any tax savings. The only common alternatives are either a proxy replacement strategy or one of the more complex options replication strategies. To replace an asset you have sold with a proxy, simply buy a like security to the one you just sold so you don’t lose the equity exposure that you desire. You do this by trying to find a company that is a very close substitute in the same industry in which you are invested. For example, if you sell a position in Pfizer at a loss you can replace it with GlaxoSmithKline. While this is often the best alternative, it is sometimes difficult to find a good match in the replacement company. While companies in the same industries often act similarly, there are often a large amount of return differences between them. Option strategies also have flaws. They are usually so expensive and complicated in execution that they have limited usefulness to the average investor. While individual securities can create problems with a tax loss harvesting strategy, there are alternatives that work well. What makes an ideal vehicle for this purpose is a portfolio made up of indexes, exchange traded funds (ETFs) or mutual funds. Most of these are inexpensive to trade and there are often several very near substitutes for most investments. This makes them ideal candidates for tax loss replacement. Take the S&P 500, for example. This is often a core holding in diversified portfolios. It also has a lot of near substitutes that can be used as replacements if it is sold for a tax loss. None of these replacements will put us in violation of any wash sale rule or cause us to lose our investment exposure. If we sold the S&P 500 it can be replaced with the Russell 1000 index, which has almost exactly the same market exposure and characteristics. The correlation coefficient between the two indexes is 0.99, which means 99 percent of one’s movement is reflected in the other. They are almost twins, but for taxable purposes they are different investments. They are not substantially identical. Most broad-based indexes and asset classes have many very near replacements available making them much more efficient to use than stocks. The most effective use of this strategy comes from having a regular investment plan where you make periodic purchases and then track them by specific lot. Every time you make an investment in a fund, or an index, identify the shares and the cost basis. Then, as you periodically check your portfolio, see if there are any viable candidates for tax loss harvesting. If so, pick the ones with the highest cost basis to sell which will maximize the realized tax loss. By minimizing taxes you move toward maximizing returns in a taxable account. Two professors from the University of California, Brad Barber at Davis and Terrance O’Dean at Cal Berkley, have done extensive research on how and when people sell their losing investments and the implications on portfolio performance. Two important points stand out. First, they found from one of their large-scale studies that investors were, on average, much more likely to sell their winners than their losers. In fact, on average, investors were 65 percent more likely to sell their winners than they were their losers. While there are several possible explanations for this bad behavior ranging from investor psychology to poor tax information, it doesn’t matter why they were doing it. What matters is the effect it had upon their portfolios. Instead of minimizing taxes, they were maximizing them. An efficient portfolio management process should focus on the harvesting and efficient reinvestment of proceeds from positions that have taxable losses. The second point that they made is that investors are much more likely to harvest tax losses at the end of the year then as an ongoing process. While this is not a bad strategy it is usually more efficient to harvest losses as they become available in the market place. In fact, any time there is a sharp correction, positions should be checked for tax loss opportunities before they rebound. Another reason you might avoid a calendar year tax loss strategy is the January effect. There have been many studies about the January effect and how a disproportionate percentage of gains in the market occur in January. One of the theories often offered is that it is the result of tax loss selling at the end of December. If you are using a sale-replication strategy where you purchase another asset whenever you sell one for a tax loss, this is not so important. But, if you are selling a stock and then waiting 30 days to buy it back, be careful. You would be better served by picking different periods in the year to harvest losses. Buying low, selling high, and holding for the long run are all great strategies if your investments always go up. If, like most of us, you occasionally have some investments that go lower and have realizable tax losses, harvest them. Make the use of an efficient tax loss harvesting policy an integral part of your investment strategy. After all, if you let the IRS share in your gains, you should also let them share in the losses. WILLIAM Z. SUPLEE IV is the president of Structured Asset Management Inc., a financial planning and investment advisory firmlocated in Paoli, Pa. He may be reached at 610-648-0700 or [email protected].

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