Resources/Weekly Insights

Volume 13, Edition 33 | December 7 - December 13, 2024

Taxes: A Painful Indication of Success

Doug Walters, CFA

In this week’s Insights, we discuss how Taxes fit into our investing Guiding Principles. We discuss how to potentially reduce taxes, but also why you may not always want to.

Contributed by Doug Walters, David Lemire, Max Berkovich

Taxes. Most cringe at the word. But for investors, it should not illicit such a negative reaction. After all, investors do not typically pay taxes on their investments unless there are realized gains. The better your investments perform, the more potential taxes there are to pay. While there are actions we can take now to help lighten that tax burden, they can have unintended consequences on portfolio risk. This delicate balance is why Taxes is one of our Guiding Principles.

We’ve all heard the phrase, “nothing is certain but death and taxes.” That’s not so in the investing world¹. If all you do is lose money on your investments, then, congratulations, you won’t have taxes to pay on them. But that is hardly success. So, let’s operate under the assumption that you want your investments to grow.

The topic of taxes is broad and complicated and touches many aspects of our planning relationship with our clients. As the Chief Investment Officer, my focus here is exclusively on actions we are taking within our investment strategies.

Minimizing taxes is not a good strategy

Let’s start with a blunt statement: minimizing taxes paid is not good investment strategy. In fact, it is not good tax strategy. Investors should be seeking to maximize after-tax investment returns, while maintaining the right level of risk. Does it make sense to want to save $1000 in taxes if doing so would reduce your investment returns by more than $1000 or unacceptably increase portfolio risk? I does not. Taxes, returns and risk must be considered together.

The dangers of tax avoidance

A common investing pitfall is artificially capping realized capital gains. It is not uncommon for investors to avoid selling some of their biggest winners with the biggest gains to stay below an arbitrary realized gain level. Over time, this increases portfolio risk:

Risk tolerance mismatch: As fiduciaries we work hard to understand our clients’ willingness and ability to take on risk. We maintain this risk tolerance by opportunistically rebalancing their portfolios weekly. But a restrictive gain limit can cause a mismatch between the portfolio and the target risk tolerance. This imbalance will grow over time if not remedied.
Concentration risk: Similar to the above, a reluctance to realize capital gains by trimming securities can lead to outsized positions in individual securities. Imagine a stock that goes up 500% and is now 20% of your portfolio. Congratulations on a great run, but you now have significant concentration risk. Company stock can go to zero overnight. Just ask owners of Enron. You don’t need that risk.

Minimizing the tax burden

So, if taxable gains are inevitable for successful investors, what can we do to help minimize that burden? We are not defenseless.

We aggressively look for opportunities in our portfolios to sell securities that are at a loss. We call this tax-loss harvesting. Those losses can be offset against your gains and reduce your tax bill.
This should not be a one-time, year-end exercise. Losses pop up and disappear regularly throughout the year. We look every week for opportunities to capture a loss.
This is more nuanced than it sounds. You may have big overall gains in a security, but individual lots may have losses that we can use.
We also avoid securities that have a history of tax inefficiency. Many mutual funds would fall into this category. We generally use ETFs which have a history of distributing far fewer gains year-to-year.
For individuals with complex situations—such as large, concentrated stock positions—strategies like exchange funds, direct indexing, and options can help manage risks without triggering significant tax liabilities. Your advisor can help you explore these alternatives.

It should be noted that taxes do not magically disappear. Your cost basis raises every time you harvest losses, so bigger gains may need to be taken in the future. By then you may be in retirement and in a lower tax bracket.

Next week, we’ll conclude our Guiding Principles series with a focus on Behavior.

1. But isn’t death a certainty for investors? Perhaps, but with careful planning your portfolio can live on indefinitely. On the other hand, there are futurists predicting we are not far off from achieving longevity escape velocity. This is the point where medical advances in extending life outpace the rate at which we age.

Our Guiding Principles

PATIENCE: Focus on the long-term to fully benefit from market returns.
DIVERSIFICATION: Enjoy the best free lunch in finance.
FACTORS: Identify market segments with a propensity for outperformance.
REBALANCING: Systematically and opportunistically, buy low and sell high.
EXPENSES: Avoid the hidden costs that quietly erode performance.
TAXES: Manage the inevitable burden for successful investors.
BEHAVIOR: Learn to get out of the way of your own worst enemy.

2.7%

November CPI Inflation

2.7% inflation was in line with expectations. Ex-food and energy, inflation was 3.3%.

Headline of the Week

To Cut or Not to Cut, That Is a Key 2025 Question

With markets viewing a December interest rate cut all but a foregone conclusion, sights are shifting to 2025 and the annual guessing game for future cuts is in full swing. This year markets seem a bit more restrained, pricing in two or three more cuts. Of course, we avoid making predictions like this, but there are interesting underlying themes for the restrained bets.

This past week’s inflation report was in line with estimates, but it did tick higher. The march back to the Fed’s 2% target was never supposed to be a straight line down and now inflation seems a bit stuck after crossing the psychologically important 3% line. The services component of inflation seems the stickiest at the moment. The employment picture remains strong, and the next administration remains a bit of a wildcard. On the other hand, some factors keeping inflation up are more transitory in nature and their lagged impact should start to fade in the new year. Markets have a history of being a bit greedy with their wish list this time of year, hopefully any recalibration doesn’t induce too much market volatility.

The Week Ahead

A jam-packed week instore for the markets: an inflation report, a rate decision from the Federal Reserve, Bank of Japan (BOJ) and Bank of England (BOE).

On the Dot!

The last Federal Reserve meeting of the year will be the biggest show, but the BOJ and BOE also face the music.

A near 100% chance of a quarter percent cut to the federal funds rate is being priced in by the markets.
The Federal Reserve may not want to disturb the holiday spirits and surprise everyone ahead of the holidays.
Investors, however, will be forced to connect some dots as a fresh batch of “dot plots” from the decision makers will chart the expected course of rates going forward.
The BOJ’s move is less certain, but given some recent headlines, they may hold steady for now.
The BOE is expected to leave rates unchanged as well, with speculation that they like the path of a cut every other meeting.

Consumption Junction

The Personal Consumption Expenditures index is the preferred inflation measure of our central bank.

Unfortunately, or maybe fortunately, the report will be released after the rate decision is made.
Expectations call for a 2.5% year-over-year increase for the headline number, and a 2.9% increase in the core number, which excludes food and energy.
The monthly increase is expected to be 0.2% for both core and headline.
Both numbers are an increase from the previous month’s reading, but in line with the general inflation trend.
As pointed out last week inflation numbers have been coming in line with expectations recently, so a surprise on the upside may be the junction at which inflation becomes a hot topic again.

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