The Subtle Art of Loss Harvesting

Doug Walters, CFA

Talk of tax loss harvesting peaks around this time of year. But there is a right and a wrong way to go about it. If you are only just thinking about it now, you should probably read on.

Contributed by Doug Walters, Max Berkovich, David Lemire,

It is the time of year when we begin to hear more and more chatter about the importance of tax loss harvesting. But this is a highly misunderstood activity. For starters, if you are just starting to think about tax-loss harvesting now, you are probably doing it wrong.

Tax loss harvesting is a term often used to describe the act of selling investments that you own at a loss in taxable accounts so that you can use those losses to offset gains when filing taxes. On the surface, it seems like a no-brainer, but loss-harvesting is far from straightforward and not for everyone. Each case is unique. We will not attempt a full loss harvesting tutorial here (I can almost hear the cheers as I write). Instead, we thought it worth highlighting some of the nuances we consider in our process.

Tax loss-harvesting is not just a year-end housekeeping activity. It should be a year-round effort to get the most out of any harvesting. Markets peak and trough throughout the year. If you only harvest losses at year-end, you may miss some “attractive” market lows.
There is no free lunch. If you sell out of a position in loss, you have to wait 30 days to repurchase it. You either face the risk of being out of the market or the risk that whatever you replace the security with underperforms. Tax-loss benefits over time are relatively small, and these risks can quickly eat up all of the benefits if not appropriately managed.
There is an assumption built into the benefits of harvesting that your tax bracket will be lower in retirement. If that is not the case, then harvesting may not be appropriate.
Tax harvesting is an excellent tool for helping to manage portfolio risks cost-effectively. Many investors have risky concentrated positions or legacy holdings that they are reluctant to part with due to large embedded gains. Losses can be used to offset the gains, resulting in a derisked portfolio that is closer to the preferred model.
Not every loss is worth selling. If you have a strong conviction holding, and there is no obvious 30-day replacement, then why would you sell it? Hold on to that position and find your losses elsewhere.

The above list is by no means exhaustive, but it highlights some of the subtleties that must be weighed when capturing losses. As evidence-based investors, we are generally proponents of tax-loss harvesting. But if you are blindly selling everything with a loss at year-end, it is probably time to upgrade your process.

18%

Developed International stock performance in Q4

The MSCI EAFE Index (developed international) is up about 18% since the start of Q4 versus the S&P 500 around 10%.

Headline of the Week

We were hoping the headline of the week would have to do with the US men’s soccer team at the World Cup, but that was not meant to be. We see some parallels between the US’s fate in the beautiful game and recent stock moves. So we’ll stretch an analogy here for the sake of manufacturing a headline for this otherwise fairly mundane week.

US large-cap stocks were down on the week, giving away some of the gains made earlier this quarter.
But US stocks are like the US men’s national team… underperforming their international peers.
So far this quarter, developed international stocks are up over 18%. Almost double their domestic peers, which are up a little over 10%.

Not too long ago, when US stocks could seemingly do no wrong, owners of well-diversified portfolios often wondered why they should own anything else. This is why!

The Week Ahead

The Federal Reserve’s rate decision on Wednesday is hands down the most important thing next week. However, on the day prior to the rate decision, the Consumer Price Index (CPI) will be huge as well.

Dotting the I

The market has gotten itself set on a ½ of 1% rate hike on Wednesday, so anything but that will be market-moving.

If the CPI report on Tuesday proves stubborn like this past week’s Purchasing Price Index, it could alter the Fed’s base case. But it would have to be a very strong inflation read to move that needle.
The Consumer Price Index is expected to come in at a similar pace as last month at 7.3% year-over-year, with a 0.6% jump in prices from the previous month. The Core CPI (excluding food and energy) is expected to be 6% year-over-year.
The bigger focus for the Central Bank’s release should be the projected rate of further hikes, “the dots.”
Of course, the dots will also reveal where the central bank thinks inflation is headed and at what pace.

Can I Have Another?

The Bank of Switzerland, Bank of England, and European Central Bank (ECB) will chime in with rate decisions next week as well.

Going into the weekend, the communication from the ECB has been a bit incoherent, so a 50 or 75-basis point hike is up in the air.
Markets are implying a 75% probability that it is ½ of 1%.
Switzerland is expected to do a token ¼ of 1% move this time.
The Bank of England is facing a double-digit inflation reading, so the market is pricing in a 9th consecutive hike, this one at ½ of 1%.
No projections nor a press conference from Bank Governor Bailey this time, so we do not expect any more clarity going into 2023.
The Pound Sterling has strengthened notably versus the U.S. Dollar, so hopes are that the stronger currency will help fight inflation as well.

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