Buy and hold

You have decided to buy and hold a portfolio of 10 stocks in a $100,000 portfolio. After four months, the total value of the portfolio has risen to $103,000. One stock, Bank of America (BAC), has dropped 30% to just $7,000, but most of the other holdings have gains.

Given your belief that BAC will bounce back from its loss, you hold onto it. Six months later, the portfolio value is $110,000. The BAC has recovered all of its loss and has a value of $11,000.

Replace a losing stock with a similar stock

Rather than holding onto the BAC after it had dropped, assume that you sold it to realize a $3,000 short-term loss. With the proceeds from the sale, you purchased $7,000 of Wells Fargo (WFC). Replacing the BAC with a similar financial stock helped to maintain the portfolio diversification.

As before, the portfolio value rose to $110,000 six months later. At that point, the WFC position had also risen to a value of $11,000.

Tax loss harvesting

Capital gains tax works in reverse for a capital loss: for the benefit of the taxpayer. You can exclude from your taxable income up to $3,000 in capital losses. If you are subject to the top 35% marginal tax rate, this exclusion lowers your tax by $1,050.

By proactively selling a stock and harvesting a loss, you gained a tax savings. The simple buy and hold approach left $1,050 on the table. If you chose to invest the savings, tax harvesting would have raised your portfolio value to $112,050.

Buy and hold could give away a tax break

Each year, taxpayers may subtract up to $3,000 in capital losses from their ordinary income. For those in the 35% tax bracket, this amounts to a tax reduction of $1,050.

Under a buy and hold strategy, an investor may not have sold any stock during 2009. By doing so, he would have avoided paying any capital gains tax.

If this investor’s portfolio had nothing but unrealized gains, he could do no better. Most investors are not that fortunate.

Sell to realize a capital loss and get a tax break

No investor is perfect with their stock picking. Anytime a new stock is purchased, a risk exists that its price may fall.

By selling a stock for a loss, an investor can lower his overall capital gains. If he realizes losses equaling $3,000, he enjoys the maximum tax break.

Offset further losses with capital gains

If the total capital loss exceeds $3,000, the excess is carried forward to the next year. Delaying by a year the benefit of the tax break dilutes its value, due to the time value of money.

One way to avoid a capital loss carry forward is to sell a different stock for a gain. This also provides a convenient chance to improve the degree of portfolio diversification. Overweighted stocks tend to be those with unrealized gains.

Let long-term capital gains wait a little longer

With its tax rate of only 15%, some investors might choose to realize a long-term capital gain. As discussed in an earlier post, unless the investor is retired and no longer adding money to the portfolio, taking such a gain is unnecessary and costly.

Get the maximum tax reduction on Schedule D

An individual’s Schedule D could have a net short-term loss of $3,000, with zero long-term capital gains. In this case, he will benefit from the maximum tax break for capital losses.

If his portfolio has unrealized losses and he reports a smaller loss, or even a gain, he may be just another irrational investor.

Diversification can dampen losses

An investor has decided to diversify by holding 10 stocks in a $100,000 portfolio. To balance the portfolio, he bought equal amounts, or $10,000, of each stock.

After three months, the total value of the portfolio has not changed. Two stocks have dropped 25% to just $7,500. On the plus side, one stock is up 50% to $15,000.

Having that gain to offset the losses shows the power of diversification. Without the $5,000 gain, the overall portfolio value could have dropped to $95,000.

Market action degrades diversification

The relative weight of the $15,000 holding has risen to 15% ($15,000 divided by $100,000). Now, the portfolio is far more sensitive to a price change in that stock.

Both of the $7,500 holdings are underweighted. Due to their small size, they now have less influence on the future performance of the portfolio.

Rebalancing could trade a potential risk for a certain cost

Equalizing the weights would restore the measure of diversification. To begin, he sells one-third, or $5,000, of the $15,000 holding and realizes a short-term gain of $1,670 (one-third of the $5,000 gain). The gain also incurs a tax of $580 ($1,670 times 35%). From the proceeds of the sale, he now has $4,420 in cash.

He then adds to the two $7,500 holdings by buying $2,210 of stock in each. While he has succeeded in balancing the portfolio, its value has dropped to $99,420, due to the tax.

Bringing a single over-weighted stock back to its target weight has cost the portfolio $580. Repeating this action each quarter might present too high a price to keep the stock weighting balanced.

Offset the balancing cost by taking a loss

Instead of adding to both of the $7,500 holdings, he could have sold one of them. Recognizing a $2,500 short-term loss would more than offset the gain.

Better yet, the net loss of $830 ($1,670 minus $2,500) would provide a tax reduction of $290. The tax penalty for rebalancing has just vanished.

Not counting the tax savings, he now has $12,500 in cash from the proceeds of the two sales. With that, he could buy $10,000 in a different stock. To adjust the weight of the remaining $7,500 holding, he could also add $2,500 in stock.

But after considering the lower tax, he would also have $290 to spare.