“Collecting more taxes than is absolutely necessary is legalized robbery.” – Calvin Coolidge
Up to and through the initial passage of the Tax Cuts and Jobs Act of 2017, stock market investors were rewarded with strongly positive returns—a classic “buy the rumor” outcome that had most investors celebrating. In typical “sell the news” response, as these changes became effective in 2018, the biggest change we have had to celebrate is increased volatility.
Generally speaking, yes. Particularly if you’re living off your portfolio and require regular distributions from it. However, volatility offers the investor something special: a way to influence (read: diminish) the painful influence of the proverbial fate worse than death (read: taxes). Volatility allows an active investor an opportunity to sell short-term losers to “harvest” the losses embedded in the investment.
While many clients begin their tax planning in the 4th quarter of each year, harvesting losses should be done whenever opportunities arise. These short-term losses can then be used to offset future gains. If you don’t have any realized gains in the near term, you can offset a small portion ($3,000) of taxes on ordinary income. Every little bit helps.
There is another benefit of the markets’ return to normal volatility: The ability to participate in harvesting the variance risk premium (VRP). VRP is a fancy term for the excess return generated from selling options. We discussed our use of this strategy in client portfolios in our Q4 2016 letter, The Cat vs. the Washing Machine. When volatility is muted, like in 2017, investors and speculators are less likely to have to pay up for the puts and calls they’ve placed. And they’re less likely to enter the market in the first place.
Options income—and just about everything in investing—is driven by supply and demand. If prices don’t move around much, the demand for someone to hedge a position by purchasing a put is diminished, thereby driving down prices. If you are the seller of options, you prefer some, but not too much, volatility.
Stock prices tend to decline much faster than they rise, although historically, they’ve tended to go up more often. Because of this difference in velocity, volatility often spikes when prices are in decline. We developed a trading strategy, our Moving Daily Average trade (MDA), to accommodate for these times.
We discussed this strategy more completely in our Q4 2017 newsletter Tactical Allocation and the MDA, and it has been a huge benefit to our clients during this equity bull run of the last nine years. 2018’s second emergence of volatility in the late spring had us take a slice out of our developed international equity allocation, and the US equity allocation is also poised for a reduction.
The imbedded gains in these positions, in other words, are set to be realized. If they’re in taxable accounts, the capital gains associated with them will be due next April. This is a good thing. This is the result of the massive wealth creation in the equity markets over the last several years.
A major component of prudent investing is selling a position after the price rises and before the price falls again. The cost of the MDA’s downside protection is in the timing of the tax burden. What is looking like a potential outcome for 2018 is that the year in which the downside protection is triggered may occur in a year in which the overall portfolio is flat or down.
These types of events, however, will reset your tax basis: They will lower the amount of taxes that you’ll owe in the future. We’re all about avoiding taxes, but according to the current tax code, the only legal way to truly evade them is to pass away. And while the tax code isn’t really 70,000 pages long (a widely held urban myth), the Form 1040 does have a checkbox to mark if you’re blind.
“Abracadabra, thus we learn the more you create, the less you earn. The less you earn, the more you’re given, the less you lead, the more you’re driven, the more destroyed, the more they feed, the more you pay, the more they need, the more you earn, the less you keep, And now I lay me down to sleep. I pray the Lord my soul to take, if the tax-collector hasn’t got it before I wake.” – Ogden Nash
For more information or questions, please contact Halbert Hargrove at email@example.com.
The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice.
All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.
This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.
It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
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