The high risk/high reward growth sector has had an incredibly fruitful run over the last decade. The sustained superior performance of this sector induced many to fall asleep behind the wheel of his or her portfolio, creating a situation where the investor’s portfolio and risk tolerance level were no longer aligned. If an investor evaluates her current portfolio and decides her (i) portfolio does not accurately reflect her true risk tolerance or (ii) portfolio is generally in decent shape but there are a few investments that are underperforming, she faces the following decision tree.
Let’s face it. If you aren’t carefully reviewing your portfolio’s overall design and monitoring its allocations, it’s easy for your investments to get out-of-whack, particularly with a far too aggressive amount of growth or technology stocks. Even the broad market – specifically the S&P 500 – has produced outsized returns for most of the last decade: 2012: 13.41%; 2013: 29.60%; 2014: 11.39%; 2015: -0.73%; 2016: 9.54%; 2017: 19.42%; 2018: -6.24%; 2019: 28.88%; 2020: 16.26%; 2021: 26.89%; 2022 (as of July 18, 2022): -20.13%. 1
Purely for illustrative purposes, let’s say an investor has been a regular purchaser of an individual growth stock for the last year or two during the pandemic when it could do no wrong, but now that portion of the investor’s portfolio has been deeply bruised to the tune of a $15,000.00 loss. Furthermore, let’s assume the investor is uncomfortable with how much of her portfolio is allocated to the individual growth stock and realizes she needs broader diversification. It is at this point that I typically hear the following from the investor:
“I want to change the construct of my portfolio, but I don’t want to sell at a loss, so I’m just going to wait it out.”
Tax loss harvesting is when you sell a floundering investment at a loss to offset gains you’ve realized from selling other stocks at a profit. The result is that you only pay taxes on your net profit, or the amount you’ve gained minus the amount you lost, thereby reducing your tax bill. Furthermore, investors can use the proceeds from selling their troubled assets to fund purchases of similar investments that the investor expects will grow over time and help recoup their losses.
An important point related to tax loss harvesting: When you sell an investment asset for a profit, you owe capital gains taxes on the profits based on how long you held the asset. If you owned it for less than one year, you’ll pay your normal income tax rate on any gains. If you held it for more than one year, you’ll owe the preferential long-term capital gains rate, which could be as low as 0% but won’t exceed 20%, even for top earners.
One thing the investor cannot do is sell a stock to realize a loss and minimize her tax burden – and then rebuy that exact same stock, or even one that’s nearlyidentical. This maneuver is referred to as a wash sale. A wash sale occurs when you sell securities at a loss and within 30 days before or after the sale buy “substantially” identical securities, or acquire a contract or option to do so.
The wash sale rule does not, however, preclude purchasing securities in the same industry. For example, you could sell shares of one company and immediately replace them with shares of a different company, even if they are in the same sector. Alternatively, you could sell your individual holding and broaden your portfolio by investing in an industry specific ETF or mutual fund that fits into your strategy. In times like this – where markets are significantly bruised – the investor may realize substantial losses and use sale proceeds to purchase other securities at bargain prices. In addition to offsetting losses against gains, new investments may enhance portfolio performance as the market recovers.
One last point: Tax loss harvesting is not beneficial in retirement accounts, such as a 401(k) or an IRA, because you can’t deduct the losses generated in a tax-deferred account.
You might be new to investing or maybe you only have a history of investing in diversified mutual funds. If either are the case, now may be a great time to dip your toe into purchasing stock of an individual company, but be sure your decision is informed. This post is not intended to be construed as a recommendation to purchase any particular company, and the investor should consider a number of factors in considering whether to purchase an individual security, including: (i) technically analyzing the security’s price history; (ii) trends in earnings growth; (iii) the company’s strength relative to its competitors; (iv) whether the debt-to-equity ratio is in line with industry norms; (v) price-earnings ratio as an indicator of valuation; (vi) how the company treats dividends; and (vii) the effectiveness of executive leadership, among other factors.
If that analysis would take up too much time or if you just aren’t interested, you may want to include an investment advisor.
Doing nothing is always an option, and for some investors this may emotionally be the best option. I’m going to make up a complete illustration to show the power of tax loss harvesting and why I hope my investors don’t decide to go with Option #3 (which, by the way, is still better than Option #4).
This chart shows a very realistic hypothetical scenario for all investors. Assume the following:
Assume this critical difference:
Five years later, on December 1, 2027, both investor’s portfolios are worth $240,000, and they decide to liquidate the entire portfolio. Here is the critical difference at that time:
Don’t. Just don’t.
Investors should be aware that a determination of the tax consequences to them should take into account their specific circumstances and that the tax law is subject to change in the future or retroactively and investors are strongly urged to consult with their own tax advisor regarding any potential strategy, investment, or transaction.
Diversification cannot eliminate the risk of investment losses. Past performance won’t guarantee future results. An investment in stocks or mutual funds can result in a loss of principal. The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek guidance from an independent tax or legal professional. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
This material was written and prepared by Davis Wealth Management, LLC. © 2022 Davis Wealth Management, LLC.
Davis Wealth Management LLC d/b/a Davis Wealth Management. James Davis offers Securities through Concourse Financial Group Securities, Inc. (CFGS), Member FINRA/SIPC. Advisory services offered through Concourse Financial Group Advisors, a DBA for CFGS, a Registered Investment Advisor. Davis Wealth Management is independent from CFGS. Please be advised that presently James Davis holds Series 7 and 66 licenses in NC and SC. For residents of other states in which registration is not held, proper licenses and registrations must be obtained by representatives before proceeding further. No part of this communication should be construed as an offer to sell any security or provide investment advice or recommendation. Securities offered through CFGS will fluctuate in value and are subject to investment risks including possible loss of principal.
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