A Yearlong Way to Boost Stock-Market Returns

Investors put a lot of energy into what they make. They should pay closer attention to what they lose.. (Image: Pixabay)
Investors put a lot of energy into what they make. They should pay closer attention to what they lose.. (Image: Pixabay)

Summary

Investors generally wait too long to harvest tax losses from their portfolios, leaving billions on the table.

Holiday lights, ugly sweaters and culling your losers.

December is the month American investors are bombarded with reminders to dig through their portfolios for the stocks or funds they wish they hadn’t bought. Their consolation prize is the ability to reap tax savings and boost long-run returns. But making tax-loss harvesting a seasonal exercise means lots of money is left on the table.

 

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With the S&P 500 up by more than 22% through the middle of December but most of those gains from a handful of stocks—Apple, Microsoft, Nvidia and the rest of the “Magnificent Seven"—this month would seem like an ideal time to make that move. There were still 185 stocks in the index on Dec. 14 that had lost money. But technological advancements now allow investors to profit from lumps of coal in their stockings any day of the year and to boost after-tax returns as a result.

Alex Michalka, vice president of investment research at robo adviser Wealthfront, notes that it wouldn’t be feasible for a human to scan their hundreds of thousands of accounts regularly for selling opportunities like its algorithms do. He cites the example of 2020, which was a solid year for stocks overall. A third of the tax losses Wealthfront harvested for its clients came in March when the pandemic sent markets diving and tax planning was the last thing on anyone’s mind. Waiting until December would have been far less fruitful.

 

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Tax-loss harvesting is the real deal—something for nothing, as long as investors don’t run afoul of the Internal Revenue Service’s wash-sale rule by buying the same security, or a substantially similar one, within 30 days. Consider the hypothetical example of an investor who buys $1,000 in Exxon Mobil stock only to watch it drop 10%. Still wanting to own a large oil company for the long term, she sells her shares for $900, swapping the investment for Chevron, which is different enough for the IRS. At her 30% marginal tax rate, the tax benefit she will receive on that year’s return is $30.

Reinvesting the $900 in cash plus the tax benefit, her Chevron stake goes on to double to $1,860 over several years. At that point she sells and pays tax at her long-term capital-gains rate of 15%, pocketing $1,720. Despite being responsible for a larger capital gain, that is still 2.4% more after taxes than just hanging on to Exxon for the same period, assuming its stock had an identical performance.

And that is only a single instance of tax-loss harvesting. The stock market gives investors multiple bites at the apple. Volatile years like 2022, when only 46 S&P 500 stocks had a gain, offer the best opportunities. But by waiting until the end of the year, many of the opportunities either will be gone or be less valuable.

The people who can reap the most bang for the buck from tax-loss harvesting are relatively young and make a lot of money. Unlike older buy-and-hold investors, they purchased stocks or funds more recently so are more likely to be sitting on losses but are still in a high-enough tax bracket to reap the benefit. That cohort is also the most likely to be comfortable using an automated solution like a robo adviser.

Wealthfront, for example, has a median client age around 36 with a high concentration of well-paid knowledge workers. Being in that sweet spot enhances the tax boost they can produce. Over several years, Wealthfront says tax-loss harvesting has added 2.88 percentage points to its clients’ after-tax returns annually.

The rise of low-cost index funds is generally a good thing, saving investors money. Over a decade, for example, S&P 500 index funds outperformed more than 90% of actively managed funds benchmarked to that index, according to S&P Dow Jones Indices. But technology now allows investors to create portfolios of individual stocks that mimic an index fund fairly cheaply. Even though 2023 had only two days when the S&P 500 was in the red, there will be some losing stocks to cull even in the best year.

Combining direct indexing with automated tax-loss harvesting can maximize the potential benefit for high-net-worth investors. It has been embraced by financial-services firms including Fidelity, Schwab, Morgan Stanley, Goldman Sachs, Bank of America, BlackRock and Wealthfront. Vanguard, the company that popularized index funds, has calculated that its personalized indexing product would add 0.34% in return a year if harvested yearly but four times as much if portfolios are scanned each day.

Investors put a lot of energy into what they make. They should pay closer attention to what they lose.

Write to Spencer Jakab at Spencer.Jakab@wsj.com

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