In a nutshell, tax-loss harvesting is when you sell investments at a loss in order to reduce your tax liability. An emotional bias called regret aversion can hamper your decision to take advantage of this strategy in an effort to increase your overall returns.
As we near the end of yet another calendar year, the opportunity to tighten up individual tax planning is slowly becoming smaller and smaller, day-by-day. At this point you probably have a pretty good idea of where you stand with itemized deductions and any specific tax strategies you may have deployed throughout the year. Some of the more advanced tax strategies take time, paperwork and planning to execute so it’s imperative you don’t wait till the last minute. However, there’s one specific strategy that can be manually completed with ease, the difficulty lies within the investor’s willingness to pull the trigger. It’s called tax-loss harvesting and it can be a key tool to use to reduce taxes.
Take this investor for example, we’ll call him John. John is meeting with his wealth advisor and accountant, jointly, for his year-end tax planning meeting. Both the advisor and the accountant advise John to liquidate part of his holding in stock XYZ for two reasons: 1) to capture a loss that will erase the long-term gains he’s realized this year and 2) to bring down his concentrated position in stock XYZ, which has been identified as a risk to his long-term wealth. John refuses to hear such nonsense! Stock XYZ has had a tough year and there are embedded losses, but it’s a company with new products being released in 2020 and analysts are very bullish! John’s wealth team reminds him that they’re not advising a liquidation of the entire holding right now, but enough to wipe out the gains on his tax reporting and strategically trim down his concentrated position in stock XYZ. John responds by saying, if “I owe taxes, that means I’ve made money!” While John is not entirely wrong in that statement, there are certainly areas here that John is overlooking:
- John is suffering from regret aversion bias. He is more nervous about regretting his decision in the future than making a logical decision in the present. Investment advisor and behavioral finance expert Michael Pompian explains: “Regret aversion can cause investors to hold on to losing positions too long. People don’t like to admit when they’re wrong, and they will go to great lengths to avoid selling a losing investment.” (Pompian, 2012, p. 247).
- By not selling a portion of his stock now, he continues to support the concentrated position in his portfolio.
To Sell or Not to Sell
What is the worst thing that can happen to John if he does strategically sell a portion of the stock? The worst thing in that scenario would be the stock does go through the roof in a few months and he misses out on the gain he would have had in proportion to what he sold (this is what he’s afraid of). However, by selling a portion of his stock, he erases his 2019 tax liability and now has capital to allocate throughout the rest of his portfolio, according to his financial plan.
What is the worst thing that can happen to John if he does not strategically sell a portion of the stock? This scenario yields far scarier results. Stock XYZ could continue to fall, his losses would continue to rise and his aversion towards regret would continue to strengthen. Now he’s even more unlikely to admit he made a mistake and would further cement himself into the camp of “waiting it out” with a security that has created a completely unnecessary dent in his portfolio, and perhaps even his long-term plan. Which would be more painful – scenario 1 or scenario 2?
“So, Thomas, are you saying we should sell all our securities when they’re down?” Great question and goodness NO. Reacting emotionally and selling when a security hits the red is not at all my advice, as you create a handful of separate risks for your long-term wealth when you do that (education on those to come in future blogs [add link to subscribe]).
My advice as always is to sit down with your tax advisor and your wealth advisor, preferably at the same time, and make sure the discussion and the strategy is customized to you. Don’t be afraid to part with losers when done strategically and don’t be afraid to watch winners continue to climb. If you’re properly diversified and your financial plan is in place, the only thing you’ll need to avoid is an emotional decision.
BerganKDV has a team of wealth advisors who can help you navigate year-end tax planning. Want to learn more about what we can do for you? Start here.
The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
The views expressed are those of BerganKDV Wealth Management. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investment advisory services and fee-based planning offered through BerganKDV Wealth Management, an SEC Registered Investment Advisor.
Pompian, M. (2012). Behavioral Finance and Wealth Management. Hoboken, NJ: John Wiley & Sons.
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December 11 | 10:30 a.m.
There is no denying that emotions and core beliefs play a large part in financial planning. The key isn’t taking your emotions out of the equation, but knowing what common money scripts are, how to identify yours and how to use them to your advantage to reach your financial goals. Do you identify with any of these money scripts? Money Worship, Money Avoidance, Money Status and Money Vigilance. You may not even realize the impact these areas are having on your financial health.