By Craig Isaacson, Vice President UBS
We can all agree that seeing our investment increase in value feels much better than seeing it drop in price. Selling the investment at a gain feels even better. Indeed, individual investors have a greater propensity to sell a stock that has gone up in value than one that has gone down. Rationally though, it makes sense for investors to sell "losers" and take advantage of an opportunity to exploit tax reductions on capital gains. However, such tax motivated selling has mostly been observed in December.
Tax loss harvesting can lead to .5% in after tax alpha on an annualized basis. But it does come at a price of psychological discomfort. Year-round tax loss harvesting means investors have to do the opposite of what feels good. The crucial point is that the strategy requires investors to:
a) proactively seek our losses all year round,
b) to focus on each losing investment and
c) to realize these losses.
Selling an investment at a loss also means dealing with regret. Acknowledging a "wrong" investment-even if it's part of a well-diversified portfolio-is not easy. No wonder tax motivated selling is mostly observed in December. It's the only time to claim tax cuts and have a fresh start in the New Year – the fresh start effect.
There are solutions to implementing loss harvesting over entire year and getting over the psychological barriers.
Loss harvesting is a strategy that should be considered by taxable investors. The benefit of this strategy is limited when losses are sold solely to offset gains at year-end. Allowing losses to drive the buy and sell decisions maximizes the benefit of loss harvesting. Unused losses can be carried forward indefinitely and do not expire until death, making them more flexible, relative to gains. Scanning for loss harvest opportunities each month, or in periods of market volatility, helps to prevent missed opportunities to harvest losses.
Special THANKS to Craig Isaacson, this month's contributing author. Please call or email him if you'd like a more comprehensive review of this strategy and how it can help improve your investment portfolio's returns.