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No. of Recommendations: 14
MFI advises selling every position after about one year -- if it's a gainer, selling after just longer than one year, to qualify for the low tax rate on long-term capital gains; if it's a loser, selling just before the year is up, to allow the short-term loss to offset ordinary income, which is taxed at the (typically higher, sometimes much higher) marginal rate.

You may feel pretty happy if each of your MFI picks gains for the year. However, for a given overall porfolio return, your after-tax returns are actually higher with a mixture of gainers and losers.

Here's an example, boldly stipulating a 30% overall portfolio return in the first year. Assume a starting porfolio of \$100,000 (say, 25 positions of \$4,000 each) in a taxable account that grows 30% after one year to \$130,000.

Scenario 1: Every stock is a winner, with overall 30% gain. You realize \$30,000 in LTCG, but have to pay 15% of this (\$4,500) in tax. Your after-tax gains are \$25,500 (25.5%).

Scenario 2: 20 of the stocks (total basis of \$80,000) are winners, with an average gain of 50%, or \$40,000 overall; the remaining 5 stocks (total basis of \$20,000) finish the year with an average loss of 50%, or \$10,000 overall. (The overall portfolio still has a gain of \$30,000, which is 30%.) The tax you owe on the gainers is 15% * \$40,000 = \$6,000. However, since you sold the losers before the year was up, the \$10,000 loss offsets \$10,000 of ordinary income. If your marginal tax rate is 25%, this reduces your taxes by \$2,500. Thus, your overall tax burden is \$6,000 - \$2,500 = \$3,500. Your after tax gains are \$26,500 (26.5%). You're \$1,000 richer than in Scenario 1.

Further, if you suppose a marginal tax rate of 35% (including state income tax), your gains with Scenario 2 would be \$27,500 (27.5%), leaving you \$2,000 richer than in Scenario 1.

The extra 1-2% per year has a remarkable effect when compounded over years and decades. It's even more pronounced if you "only" generate 20% per year, instead of the 30% that we've been assuming.

The point is that, if you're going to generate satisfactory overall returns (and this is the key assumption and hope, of course), a program of holding winners/losers just more/less than one year, respectively, maximizes your after-tax returns, and actually benefits from wide variations in the returns of the individual stocks.

Having every stock go up 30% in a year is terrific (we should all be so lucky). However, having the overall portfolio go up 30%, due to some super-gainers going up more than 30% and some stinkers losing value over the year, actually leads to higher after-tax income for us.

Many people would find Scenario 1 more satisfying than Scenario 2. After all, the latter feels much "riskier", and loss aversion may make us attach too much weight to the 5 losing stocks ("if only I hadn't bought these, I would have generated 50% returns instead of a mere 30%!"). To cushion the wild ride, remind yourself that the "lumpy" 30% of Scenario 2 leaves more money in your pocket than the "smooth" 30% of Scenario 1.

Hope this helps,
ValueFocused