With 2014 drawing to a close, that time-honored tradition of harvesting losses to offset gains is upon us yet again. However, this year offers a new twist: losses are hard to find amid broadly positive financial market conditions. Even mutual fund managers will find it difficult to avoid reporting capital gains distributions this year. As such, investors may want to take a different approach. Instead of fearing capital gains, embrace them. After all, they’re gains!
People Dislike Paying Taxes
According to Gallup, a majority of Americans consistently think they pay more than their fair share in taxes. And a recent study indicates that if given the choice between purchasing a product nearby at a discount versus having to travel some distance for an equivalent sales tax holiday, considerably more people would take the trip to avoid having to pay the tax.
The same attitude about taxes persists in the world of investments. Every year, taxable portfolios are assessed to find losses to offset capital gains. But what happens if our resistance to paying taxes leads to suboptimal outcomes? Investors often cite capital gains as a reason to not sell an investment that has done well because doing so would raise their tax obligation. This reluctance to sell is true even if the investment is expensive. Conversely, taking capital losses on investments that have done poorly to offset a gain might mean selling an investment just when it has become cheap.
Clearly, investors dislike paying taxes so much that they will take losses to offset gains (or not sell to avoid paying taxes) regardless of valuation considerations. This seems somewhat irrational. Have you ever known someone to turn down a promotion because it put them in a higher tax bracket? Obviously not. Similarly, if you’re disappointed that your portfolio is doing well simply because of capital gains liability, then something is a bit off. Gains should be celebrated, not loathed.
Time to Rebalance
To aid in the celebration, here are a few investment ideas that may go against the grain from a tax perspective but that could enhance future performance and minimize risks in your portfolio.
1. Bring your portfolio back into better balance: Have you let your winners ride during the past five years to avoid a capital gains tax hit? If so, then your portfolio may have morphed into ever higher risk exposures. If you are over exposed to stocks and corporate bonds (both investment grade and high yield) as a result of their impressive gains, then ask whether these exposures are still appropriate or if you might want to consider rebalancing toward other assets that could potentially provide ballast, such as government bonds, or add diversification, international funds.
2. Shed some expensive defensives: Within the stock market, we have seen the segments that are least susceptible to swings in the overall economy and that pay a high dividend yield, such as consumer staples and utilities, are becoming more expensive amid concerns about the health of the global economy and demand for yield. Depending on individual goals and outlooks, some investors may want to lock in gains in these sectors and redeploy the proceeds into sectors that are currently less pricey, such as financials or even select energy.
3. Don’t abandon emerging markets: One of the few areas that have languished during the past five years – emerging markets – may be the wrong investment for some investors to abandon now, especially if the justification is to book a loss to offset a gain. Although selectivity in emerging markets is crucial, we think valuations have improved sufficiently to warrant some exposure for most investors.
4. Consider harvesting capital gains to meet an income objective: These days, investors are looking high and higher to find income. One option for income might be to harvest some of the long-term capital gains in your fixed income portfolio and pay the proceeds out as income over time. In any case, capital gains taxes are preferential to taxes on interest income. In a low yield environment, investors are looking at every potential source – stocks, bonds, alternatives and investment gains – to generate income in portfolios.
Again, depending on your individual goals, you might want to consider selling recently purchased funds that estimate large capital gains distributions this year before year end. Be alert because it is possible to owe capital gains on an investment even if you didn’t own it when the gain was realized. But also be aware of your behavioral aversion to paying taxes. Overcoming these tendencies could lead you to better investment decisions.
Kurt Reiman is a Global Investment Strategist at BlackRock, working with Chief Investment Strategist Russ Koesterich. He wrote this post exclusively for The Blog.