Tax-loss harvesting as a behavioral tool

It’s extremely hard to invest when markets are down. We all know it’s the “right” thing to do, but it’s hard to act in the face of fear.

Unfortunately, the popular media doesn’t help. As an investing culture, we have a gaggle of catchphrases that warn you away from buying when things get tough. Aphorisms like “don’t catch a falling knife,” “the trend is your friend,” “avoid value traps” litter the investing landscape. Each time the market gets topsy-turvy, CNBC posts images of a ravaging bear, claws and fangs ready to ravage your investment portfolio. As we wrote in How To Invest In A Falling Market, it’s no surprise that study after study finds investors tend to buy high and sell low.

We think that fighting this trend – having an investment plan and sticking to it – is one of the single most important things you can do to succeed as an investor. Despite how much we focus on fees in this blog, bad behavior is the single biggest destroyer of long-term returns for the average investor.

It’s for this reason that we’ve written a lot about this over the past year. In What You Should Do in Volatile and Uncertain Markets, investment legend Burt Malkiel laid out the case for dollar-cost averaging into markets of all types.

In Invest Despite Volatility, we made the argument for why investing in a steady downward trending market can actually lead to a better long term outcome for your retirement than a steadily increasing market.

And in There’s No Need to Fear A Stock Market Corrections, we explained that markets take approximately the same amount of time to get back to their peak as they took from peak to trough. Over the past 50 years the average time to recover from a 10% market correction was less than four months!

All the rational parts of our minds know this is true. And yet, human beings aren’t rational.

Fortunately, we think there’s an automated investment service that has an additional behavioral benefit that (we hope) can push people over the edge: tax-loss harvesting.

Tax-Loss Harvesting As a Behavioral Tool

Our tax-loss harvesting tool takes advantage of pullbacks in individual securities to lock in tax savings for clients. While most of us hate market pullbacks, to our tax-loss harvesting algorithm, they are like an early Christmas.

For example, in September, the S&P 500 closed the month down 2.64%. That’s painful. Behavioral studies show that people tend to extrapolate out from recent returns and expect them to continue into the future, and projecting a long-term decline in the market is painful.

Fortunately, thanks to our tax-loss harvesting algorithm, Wealthfront investors had ballast against this painful market. As we wrote in How to Protect your Portfolio: Tax Loss Harvesting, TLH is one of the best tools to provide an offsetting economic benefit … better, perhaps, even than diversification. In September, for instance, our TLH system generated 1.18% in tax alpha (the after tax benefit from tax-loss harvesting expressed as a percentage of portfolio value), recovering almost half the market downdraft. In Q3 our average tax-loss harvesting client received an after tax benefit of 2.11%. Those are not projections or estimates; those are real numbers!

In short, TLH has your back in falling markets. Knowing your downside is partially protected should give you more confidence to invest in a challenging market, which will allow you to take advantage of all the benefits described in our earlier referenced blogs.

An Additional Benefit

Based on anecdotal feedback from clients, there may be an additional behavioral benefit to tax-loss harvesting as well. When markets pull back, investors have a natural tendency to want to do … something. It’s hard to just sit there and watch your portfolio when the market is down. Investors have a bias-towards-action.

TLH scratches that itch. Investors who worried about their portfolios in Q3 were able to log-in to their accounts and see exactly what was happening inside. They saw that our service had a plan for how to cope with market pullbacks and that it was executing on that plan, selling certain securities and buying others. You could see each sale as it took place, and the total amount of losses harvested as a result. The engagement provided useful activity … without harmful behavior like selling out at the low.

In sum, buying during troubled markets is hard. It’s why we write about it so much. Our hope is that, if you know your TLH algorithm has your back, it will be a little bit easier to make the right choice the next time the market hits a hiccup.

Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. This article is not intended as tax advice, and Wealthfront does not represent in any manner that the tax consequences described here will be obtained or that Wealthfront’s investment strategy will result in any particular tax consequence. The tax consequences of this strategy and other Wealthfront strategies are complex and uncertain and may be subject to challenge by the IRS.

Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in a tax strategy, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority. When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.

Projected after tax returns for Wealthfronts Tax-Loss Harvesting strategies are intended to show only an expected possible outcome based on historical average returns for a typical Wealthfront account. To calculate the potential after tax savings of a typical Wealthfront client we assume a married couple filing jointly in California, combined federal and state short-term capital gain tax rate of 42.7%, combined federal and state long-term capital gain tax rate of 24.7%, and a risk score of 7.
Several processes, assumptions and data sources were used to create one possible approximation of how Wealthfront’s tax-loss harvesting strategy might have benefited investors in the past, and a different methodology may have resulted in different outcomes. The results of the historical simulations are intended to be used to help explain possible benefits of the tax-loss harvesting strategy and should not be relied upon for predicting future performance. The results were achieved by means of the retroactive application of a model designed with the benefit of hindsight. The projected returns consider dividend reinvestment, and interest but do not take into consideration commissions, the effect of taxes, changing risk profiles, or future investment decisions. Projected returns do not represent actual accounts and may not reflect the effect of material economic and market factors. Past performance is no guarantee of future results. Actual investors on Wealthfront may experience different results from the results shown.


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