Rule of thumb for when not to TLH into cash

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grabiner
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Rule of thumb for when not to TLH into cash

Post by grabiner » Sat May 12, 2012 10:18 pm

A discussion on another thread led me to look at the costs of tax-loss harvesting and putting the money in cash for 31 days rather than finding a replacement fund.

I would suggest the following rule of thumb; when harvesting a loss, keep the money in cash for simplicity unless the harvest would take you outside your rebalancing bands.

Moving money from stocks to bonds costs you in expected value, but not in risk-adjusted return. Presumably, you have chosen your asset allocation at the level at which changing your allocation doesn't affect your preferences much. For example, if you have 60% stock, you probably don't have a strong preference for 60% over 59%; if you did, then you would presumably prefer 61% over 60% as well, and would increase your stock allocation. This is the same logic as rebalancing bands; the reason you will only rebalance if your allocation drops outside the range of 55% to 65% is that you don't care much about allocations within that range.

Moving money from bonds to cash costs you in both expected value and risk-adjusted return, because cash has a lower return than bonds but adds very little risk reduction to your portfolio.

Thus, if you sell a small amount of stock and buy bonds, that doesn't make your portfolio any worse, and then if you sell bonds and keep the money in a money-market fund, that does. Leaving out the intermediate step, the cost of selling stock to buy a money-market fund in risk-adjusted returns is the difference between bond and cash returns, which is usually about 2%. If you are in the money market for 31 days, the cost is 31/365 of 2%, which is 0.17%, or $17 on a $10,000 harvest. If you are holding an ETF as a replacement fund, you may lose more than that $17 to commissions, spreads, and the value of your time trading the ETF. Even if you are holding a mutual fund so that the transaction is free, it's not much of a cost keeping the cash, and it simplifies your accounting.

There are two exceptions, in which the cost might be significant. If you are doing a harvest of a large fraction of your portfolio, the risk-adjusted cost is non-trivial; if you harvest 10% of your total portfolio, then you have dropped from 60% stock to 50%, unless you either buy replacement stock or adjust the allocation of your tax-deferred accounts.

A less likely exception is that you might harvest a large dollar loss in a huge portfolio. If your portfolio is $2M and you harvest $50,000, that is 2.5% and may not move you outside a rebalancing band, but the dollar cost becomes $85, and it may be worth finding a replacement fund.

Even in these cases, you wouldn't necessarily want to switch to the closest replacement. If you are harvesting a large loss and the closest equivalent fund is an illiquid ETF, you may lose more to the spread than you gain in risk-adjusted returns. For example, I now hold EEMS, an emerging markets small-cap ETF. If I harvest a loss there and decide to stay in a replacement fund, I wouldn't use EWX, which is the other emerging markets small-cap ETF, as I would expect to lose about 0.4% to the spread from buying it and then selling it 31 days later. Rather, I would use Emerging Markets Index, which keeps the emerging markets but not the small-cap exposure, and which costs nothing to trade as a mutual fund (I already have Admiral shares) and very little as an ETF because it has a huge volume and normally trades at a one-cent spread.
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Re: Rule of thumb for when not to TLH into cash

Post by livesoft » Sat May 12, 2012 10:32 pm

I like this. But I recommend looking to TLH on a ReallyBadDay which means I change my asset allocation for that day to force rebalancing. Thus at least for me, this is another push to make sure that I do not TLH into cash.

Let's face it, one should not have to TLH if the market has been going up and is rosy. TLH should be happening mostly when the market is going down and going down in a big way. By TLHing into cash at a time when one should be rebalancing into equities, one is defeating the purpose of asset allocation. Your idea helps folks realize this and attempts to make sure they follow their AA plan.
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Re: Rule of thumb for when not to TLH into cash

Post by grabiner » Sat May 12, 2012 10:48 pm

livesoft wrote:Let's face it, one should not have to TLH if the market has been going up and is rosy. TLH should be happening mostly when the market is going down and going down in a big way. By TLHing into cash at a time when one should be rebalancing into equities, one is defeating the purpose of asset allocation. Your idea helps folks realize this and attempts to make sure they follow their AA plan.


However, there is often enough flexibility in rebalancing bands that you can TLH into cash despite a market decline. Suppose that your target allocation to stock is 60%, with a band of 55% to 65%. You hold $300,000 in stock, and $200,000 in bonds; this allocation was set when you made your last stock purchase of $12,500, which was 2.5% of your portfolio. The market drops 10%, so you now hold $270,000 in stock, which is 57.7% of your portfolio. You could harvest the lot you purchased for $12,500, which is now worth $11,250; that would leave you with $258,750 in stock, which is just over 55%.

But if the stock market drops by 20% (and you haven't already harvested your loss, possibly because you didn't have any significant losses to harvest at the time), you have already gone past your rebalancing band; your portfolio of $440,000 has $240,000 in stock, and 55% of the total is $242,000. Thus you need to rebalance, and you can TLH at the same time. You might still TLH into cash, if you can make the rebalancing adjustment within your retirement accounts.
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Re: Rule of thumb for when not to TLH into cash

Post by xerty24 » Sat May 12, 2012 11:29 pm

I think your first exception is more likely the rule than an exception. Markets are highly correlated during down periods, and I would not at all be surprised if most or all of your stock positions would be ready for TLH by the time you're ready to do it. If you're at 60/40, you're probably going to need to swap 40+/60 of your stocks so that's taking a huge position during a volatile time by being in cash/bonds instead of stocks per your AA.

I'm not sure the risk-adjusted return of bonds is the same as stocks, but they're probably close enough (both fairly poor).

I would emphasize your point about EEMS vs EEM more. If you have serious reservations about holding the second best TLH substitute for the long term (say if markets recover and now you have a big unrealized gain), whether due to excess ER or poor liquidity or credit risk (ETN vs ETF), I think one would be better off taking a not-quite-so-similar proxy that was more accessible than a quite similar one with more drawbacks. I definitely use this latter approach in practice.
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Re: Rule of thumb for when not to TLH into cash

Post by Cash » Sun May 13, 2012 9:41 am

grabiner wrote:A discussion on another thread led me to look at the costs of tax-loss harvesting and putting the money in cash for 31 days rather than finding a replacement fund.

I would suggest the following rule of thumb; when harvesting a loss, keep the money in cash for simplicity unless the harvest would take you outside your rebalancing bands.


I like this rule, and thanks for taking the time to do the analysis (I think my tangent prompted the discussion). In thinking about it on and off yesterday, I also concluded that cash/simplicity might win unless there is a really big drop. I think "outside your rebalancing bands" is a better way to put it.

xerty24 wrote:I think your first exception is more likely the rule than an exception. Markets are highly correlated during down periods, and I would not at all be surprised if most or all of your stock positions would be ready for TLH by the time you're ready to do it.


Sure, but the question is how much those positions would be worth as a percentage of your portfolio. Unless your positions have been flat for an extended period, your older lots will have a significantly lower basis than your more recent lots. So maybe last month's or the last few months' contributions will be ripe for harvesting, but those lots are likely pretty small relative to your remaining positions. Except in exceptional circumstances such as the beginning of recessionary periods or the midst of some other market crisis, your harvest will probably not be a large portion of your equity holdings, and the remainder of those holdings will still be there working for you during the 31-day period.

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Re: Rule of thumb for when not to TLH into cash

Post by livesoft » Sun May 13, 2012 9:44 am

Cash wrote:.... So maybe last month's or the last few months' contributions will be ripe for harvesting, but those lots are likely pretty small relative to your remaining positions. Except in exceptional circumstances such as the beginning of recessionary periods or the midst of some other market crisis, your harvest will probably not be a large portion of your equity holdings, and the remainder of those holdings will still be there working for you during the 31-day period.

And if you never hold a losing position past the short-term (one-year) mark you won't have losers for long ("Except in exceptional circumstances ....").
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Re: Rule of thumb for when not to TLH into cash

Post by Default User BR » Sun May 13, 2012 1:16 pm

I've always just replaced the TLHed equities with an adequately equivalent one. That's simpler for me.


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Re: Rule of thumb for when not to TLH into cash

Post by grabiner » Sun May 13, 2012 3:21 pm

xerty24 wrote:I think your first exception is more likely the rule than an exception. Markets are highly correlated during down periods, and I would not at all be surprised if most or all of your stock positions would be ready for TLH by the time you're ready to do it. If you're at 60/40, you're probably going to need to swap 40+/60 of your stocks so that's taking a huge position during a volatile time by being in cash/bonds instead of stocks per your AA.


Not over a long history of holding the funds, because the market will (usually) have gone up over the time. In a bear market like 2007-2009, you may have years worth of purchases to harvest; my entire Total Stock Market Index dating back to 1997 was underwater in March 2009, and I sold all but one of my lots. (My international funds did better, and I kept half of them.) But in a more normal bear, say a 20% decrease following a 25% increase the previous year, only your purchases from the last year will have losses.
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