Risks and costs of Tax Loss Harvesting

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Spades
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Risks and costs of Tax Loss Harvesting

Post by Spades »

Howdy All,

So I did my first round of purposeful tax loss harvesting (TLH) with my bonds. I was curious what everyone thought were the risk and costs of TLH.

Risks:
1. The biggest risk I can think of is if the investments that are sold are repurchased at a new price greater than the net tax savings.
2. Lossing some of the value of the investments sold if placed into a riskier investment than a savings account (my sale is relaxing in checking for a month).

Costs:
1. Lossing out on interest and dividends for 31 days.

So what do y'all think?

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mhc
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Re: Risks and costs of Tax Loss Harvesting

Post by mhc »

I think you can eliminate the risks you listed if you invest the money in an alternate fund rather than having it sit in savings. This may not always be an option though.

Another risk you face is forgetting to re-invest the money at the end of 31 days.
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House Blend
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Re: Risks and costs of Tax Loss Harvesting

Post by House Blend »

This is not what I would do.

First, I would not "purposefully" TLH bonds. I stick with equities for TLH. If I had to sell bonds in taxable, I would of course sell the shares that minimize my taxes--any losses harvested would be an accidental bonus.

Second, I would not park the proceeds in cash [*]. I would exchange for a similar but not "substantially identical" fund. And plan on holding shares of the new fund forever, if necessary.

YMMV.

[*] I had to learn this the hard way. It is a little-known fact that I singlehandedly turned the stock market around back on March 2, 2009, when I loss-harvested some shares of TSM and decided it would be harmless to leave those shares in cash for 31 days.
livesoft
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Re: Risks and costs of Tax Loss Harvesting

Post by livesoft »

I would have no problems doing TLH of a bond fund ... if I had a bond fund in a taxable account and it lost money. Indeed, I would not buy any fund in taxable unless I already had earmarked the fund that I would use to TLH it.

For example, suppose I bought Vanguard Total Bond Market Index in taxable and it lost money. I would just exchange Total Bond Market Index fund into the Intermediate-term bond index fund.

Thus, there would be no risks and no costs for doing the tax-loss harvesting.
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Spades
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Re: Risks and costs of Tax Loss Harvesting

Post by Spades »

livesoft wrote:I would have no problems doing TLH of a bond fund ... if I had a bond fund in a taxable account and it lost money. Indeed, I would not buy any fund in taxable unless I already had earmarked the fund that I would use to TLH it.

For example, suppose I bought Vanguard Total Bond Market Index in taxable and it lost money. I would just exchange Total Bond Market Index fund into the Intermediate-term bond index fund.

Thus, there would be no risks and no costs for doing the tax-loss harvesting.
Great idea, I didn't think about that. Yeah, well I re-adjusted some time ago and then bonds fell a little bit. So I'm stuck in this situation because I invested a lot of my income directly into taxable and maxed out my ROTH IRA and not my TSP. as well You might have done the same if you move at least every 3 years, won't buy a house until you get out of the military, and need to build up a taxable amount for buying a house.

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Spades
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Re: Risks and costs of Tax Loss Harvesting

Post by Spades »

Just a quick update since I've submitted my taxes. I'm happy to report that Tax Loss Harvesting lowered my income a decent amount this year. Hopefully, if the situation arises for more TLH this year I can move the funds into a reallocation to my Asset Allocation Plan.

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dbr
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Re: Risks and costs of Tax Loss Harvesting

Post by dbr »

Spades wrote:Howdy All,

So I did my first round of purposeful tax loss harvesting (TLH) with my bonds. I was curious what everyone thought were the risk and costs of TLH.

Risks:
1. The biggest risk I can think of is if the investments that are sold are repurchased at a new price greater than the net tax savings.
2. Lossing some of the value of the investments sold if placed into a riskier investment than a savings account (my sale is relaxing in checking for a month).

So if you don't tax loss harvest here are the risks:

1. The investments could have been repurchased at a new price less than where you sold.
2. Not avoiding a loss to the investments by holding them in a less risky investment.

And here is a certainty:

You would lose the benefit of tax loss harvesting.

Costs:
1. Lossing out on interest and dividends for 31 days.

That isn't a risk; it is a certainty if you time it wrong. If you really are going to miss a dividend, then make sure you don't. Bond fund interest accrues, so you won;t miss it.

So what do y'all think?

You should always tax loss harvest when you have a reasonable opportunity. There are people who go nuts over being out of the market for a month, but the cold-blooded proposition is that you are losing no more than 1/12 of the annual expected return and you can have a system of replacement funds that work if you don't like that. It doesn't bother me in the slightest to be out of the market for a month.


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Re: Risks and costs of Tax Loss Harvesting

Post by Spades »

Thank you for the response DBR. I think your recommendation for not worrying about being out the market for 1/12th of the time is a good one. I would like to point out that I listed both costs and risks. The certainties are the costs, or benefits. What do you think is a reasonable opportunity for TLH?

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livesoft
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Re: Risks and costs of Tax Loss Harvesting

Post by livesoft »

I think the idea that being out of the market for 1/12th of the time is a big problem. Here is why:

One should be tax-loss harvesting when one has a loss and not when one has a big gain. Duh! When the market has dropped enough to have a loss that is worth tax loss harvesting, then the chances of the market going up from that point are better than the chances of the market going down from that point.

A simple very recent example shows this. Suppose on Feb 3rd (a RBD for some things), one tax-loss harvested. RBDs are noted to be good days to TLH. If one sat out of the market for VWO or VXF since the close of Feb 3rd a mere 3 weeks ago, they would have missed out on gains (not counting today) of about 5% and 7% which may turn out to be most of the gains for all of 2014.

Even with bond funds back in June 2013, they popped up within a month of the low.

It is this asymmetry and/or stochasticness of the drops that cause one to TLH that makes avoiding sitting out for 31 days important.
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Re: Risks and costs of Tax Loss Harvesting

Post by Wagnerjb »

livesoft wrote:Duh! When the market has dropped enough to have a loss that is worth tax loss harvesting, then the chances of the market going up from that point are better than the chances of the market going down from that point.
Actually not. On any individual day, the changes of the market going up are the same. The market doesn't care what happened yesterday and every day it is priced with an expectation of a gradual increase. This is called autocorrelation in statistics and it has been proven through an awful lot of research. (Actually, the purists might point out that there is a tiny autocorrelation on the positive side - momentum, but not enough to make money chasing it).

If you TLH often enough over your lifetime, you will diversify away the bad luck and the good luck. Some of the 31-day periods will have gains, some will have losses. Over a lifetime these should even out, such that you are missing the equity premium over those periods (difference between equities and safe bonds).

When you make the decision to TLH, you have to expect to lose the equity premium if you wait 31 days. Of course it is best to immediately reinvest the proceeds in a similar security, but sitting out of the market for 31 days won't be fatal.

It also depends on how tiny your asset slices are. If you are harvesting the one fund you own - for global stocks - then the impact is greater if you wait 31 days to reinvest. But if you are harvesting a tiny slice (say international small value), the impact is a whole lot less significant. The more small slices you have, the more TLH opportunities you have. And....the more small slices you have, the more 31-day periods you will have over your lifetime and the more the luck will diversify away.

Best wishes.
Andy
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Re: Risks and costs of Tax Loss Harvesting

Post by livesoft »

Wagnerjb wrote:
livesoft wrote:Duh! When the market has dropped enough to have a loss that is worth tax loss harvesting, then the chances of the market going up from that point are better than the chances of the market going down from that point.
Actually not. On any individual day, the changes of the market going up are the same. The market doesn't care what happened yesterday and every day it is priced with an expectation of a gradual increase. This is called autocorrelation in statistics and it has been proven through an awful lot of research. (Actually, the purists might point out that there is a tiny autocorrelation on the positive side - momentum, but not enough to make money chasing it).
Actually, what you write is simply not true. A critical reading of that "awful lot of research" should lead one to see why.

I can also invoke the "Lump Sum vs DCA" debate here. The day you sell your position at a loss, you create a bit of cash that you can lump sum back into the market that day or you can use a 1-month DCA schedule and put the money back into the market in 31 days. :twisted: So are you saying DCA is better than LS?
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dbr
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Re: Risks and costs of Tax Loss Harvesting

Post by dbr »

livesoft wrote:I think the idea that being out of the market for 1/12th of the time is a big problem. Here is why:

One should be tax-loss harvesting when one has a loss and not when one has a big gain. Duh! When the market has dropped enough to have a loss that is worth tax loss harvesting, then the chances of the market going up from that point are better than the chances of the market going down from that point.

A simple very recent example shows this. Suppose on Feb 3rd (a RBD for some things), one tax-loss harvested. RBDs are noted to be good days to TLH. If one sat out of the market for VWO or VXF since the close of Feb 3rd a mere 3 weeks ago, they would have missed out on gains (not counting today) of about 5% and 7% which may turn out to be most of the gains for all of 2014.

Even with bond funds back in June 2013, they popped up within a month of the low.

It is this asymmetry and/or stochasticness of the drops that cause one to TLH that makes avoiding sitting out for 31 days important.
These are propositions that you, or someone, should be able to prove from actual data. I am not opposed to acknowledging demonstrated facts, but I don't worry much about it either. It might turn out to be dancing on the head of a pin. Important is an evaluation that needs to be quantified, especially if there is an offset, such as changing over to alternate investments that one does not really want to hold indefinitely and that one is unable to unload for an extended time afterward.

I interpret the word stochastic to mean random or governed by chance. In this case that should mean that the future course of the investment is independent of the past course, which is the opposite of what you need for your asymmetry and would be the expected return estimate I mentioned. On the other hand, one could be allowed a stochastic process with negative serial correlation on a one month time scale that would indeed suggest that it would be an advantage to stay in the market.
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Re: Risks and costs of Tax Loss Harvesting

Post by Wagnerjb »

livesoft wrote: A critical reading of that "awful lot of research" should lead one to see why.
Well, I actually did an awful lot of critical reading of the research when I was studying for my Masters in Finance :D
I can also invoke the "Lump Sum vs DCA" debate here. The day you sell your position at a loss, you create a bit of cash that you can lump sum back into the market that day or you can use a 1-month DCA schedule and put the money back into the market in 31 days. So are you saying DCA is better than LS?
Due to market efficiency, you have the same expectation every single day in the stock market - that is, that the market will rise slightly. The market has already reflected yesterday's news completely, so yesterday is irrelevant. Therefore, it is better to Lump Sum any idle cash as opposed to DCA'ing the money. But since we are human and tend to be irrational about money, it is better for some (psychologically) to DCA in order to avoid the feelings of regret. However, if you are putting money into the market many times over many years, the bad luck will offset the good luck and you will come out ahead of DCA'ing.

Best wishes.
Andy
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Re: Risks and costs of Tax Loss Harvesting

Post by livesoft »

I will agree that most days due to market efficiency that one might have the same expectation, however, there is a category of days where the expectation is quite a bit different. It doesn't mean the expectation always happens, but it means that it ain't the same ol' same ol' and one should expect something different than the standard book expectation. That is, don't believe everything you read whether on the internet or published in books or scholarly journals.
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Re: Risks and costs of Tax Loss Harvesting

Post by Sagenick48 »

I have been tax loss harvesting for as long as I can remember, sometimes replacing, other times, just taking the losses in a year when I can offset my capital losses against my ordinary income, Even after the crash of 2008-9, I had no capital losses
showing by mid 2010.

The only risk I see with tax loss harvesting is that it assumes tax rates and marginal tax brackets will remain constant. You can't count on either of these and given the complications of the tax code and the phasing out of credits, deductions, exemptions, taxability of social security, AMT etc,etc, it should not be an end in itself.

In the end, tax loss harvesting is a good excuse to clean out the dogs and losers in your portfolio, but not as an end in itself.
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Re: Risks and costs of Tax Loss Harvesting

Post by Don Christy »

I don't understand what the big argument is. You don't need to be out of the market to TLH, so who cares what the expectation is? I probably would not choose to TLH if I had to be out of the market, especially after a RBD. But That's not how I TLH. I identify reasonably similar (for me) funds and exchange creating the loss. I'm simply TLHing to offset current ordinary income with future cap gains.
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Re: Risks and costs of Tax Loss Harvesting

Post by kenyan »

I haven't ever used a TLH strategy, but I know that if/when I position myself to have taxable investments again, I will do so in a manner that will allow me to immediately repurchase a similar but not substantially identical investment. I don't personally like the 'out of the market for 31 days' method.
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Re: Risks and costs of Tax Loss Harvesting

Post by Spades »

kenyan wrote:I haven't ever used a TLH strategy, but I know that if/when I position myself to have taxable investments again, I will do so in a manner that will allow me to immediately repurchase a similar but not substantially identical investment. I don't personally like the 'out of the market for 31 days' method.
Kenyan,

When you are able to position yourself, I highly recommend it. It saved a significant amount in taxes for me, just this year. I think I will take Don Christy's, Livesoft's, and DBR's advice to find a way to stay in the market. I did enjoy their discussion in HOW to stay in the market while tax loss harvesting.

Right now, I'm leaning lump summing :twisted: .

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Re: Risks and costs of Tax Loss Harvesting

Post by kenyan »

Spades wrote:
kenyan wrote:I haven't ever used a TLH strategy, but I know that if/when I position myself to have taxable investments again, I will do so in a manner that will allow me to immediately repurchase a similar but not substantially identical investment. I don't personally like the 'out of the market for 31 days' method.
Kenyan,

When you are able to position yourself, I highly recommend it. It saved a significant amount in taxes for me, just this year. I think I will take Don Christy's, Livesoft's, and DBR's advice to find a way to stay in the market. I did enjoy their discussion in HOW to stay in the market while tax loss harvesting.

Right now, I'm leaning lump summing :twisted: .

:sharebeer
That's what I mean. I will tax loss harvest when appropriate, but will use a strategy that keeps me invested in the market. If using mutual funds, that might mean being 'out of the game' for one day, but that's a lot better than 31 days.
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