Taxes, Portfolio Management and Emotional Pain
Thursday, April 4, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Best Practices for Rebalancing
A 10-percentage-point trigger can lower the number of transactions.

Dishonesty, Choices and Investing
Actions are often justified, even when they are unnecessarily costly.

AAII Discussion Boards
How do you strike a balance between allocation goals and taxes?

Most Popular AAII Articles

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 35.5%, down 2.9 points
  Neutral: 36.3%, up 3.4 points
  Bearish: 28.2%, down 0.5 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »


Loss aversion may cause some investors to make portfolio decisions based primarily on the tax consequences instead of on strategies intended to provide a long-term benefit. The short-term pain of tax payment is felt more than the future pain of the increased volatility stemming from a portfolio that is not properly allocated. This is a conclusion I’m reaching from reading some of the comments to the articles about rebalancing in the April AAII Journal and what I’ve been learning about behavioral finance.

Allow me to explain the logic behind this.

As humans, we tend to be risk-averse. The pain of a loss is greater than the pleasure of a gain. From a purely survival instinct, favoring the avoidance of pain over the pursuit of pleasure is a good thing. It keeps us from getting into situations we perceive as dangerous (e.g., stepping too close to the edge of a cliff in hopes of getting a better view). In finance, however, it can cause us to focus on short-term events with the potential of causing long-term harm to our portfolios.

Using portfolio rebalancing as an example, if your allocation strategy prompts you to take profits following a stock rally and you do this in a taxable account, you will have capital gains taxes to pay by the end of the calendar year (or quarter, if you pay estimated taxes). The upside is that you will have reduced your portfolio’s long-term volatility and better positioned it to ride through inevitable correction or a bear market that follows a rally. The benefit of rebalancing is not always apparent in the year that capital gains are realized, but the pain of the tax bill is. So, which do you feel more? The tax bill, of course.

There is another component to this. Think about how you pay your taxes: MasterCard? American Express? Nope, you most likely write a check or, if you file electronically, have a withdrawal made from your checking account. (The IRS does allow credit card payments, but an additional fee of approximately 2% is charged, making it a potentially costly option.)

Payment by cash for goods and services is more painful than payment by credit card, especially for someone who is not a spendthrift. It seems probable that the same observation applies to those who really dislike paying taxes. Though nobody actually likes paying taxes, some people are more tolerant than others.

I’ll put a bit research behind the observation about payment methods. A paper I’m reading as part of an online behavioral finance course by Duke University professor Dan Ariely compared impulsive purchases of unhealthy foods (e.g. Oreos) among those who paid by cash and those who paid by credit card. The impulsive purchases jumped when a person classified as a thrifty individual by the researchers used a credit card rather than cash. Why? Because the cash outlay was an immediate cost, whereas the credit card payment was not. (A liability was created, but the outflow of wealth was delayed to a future point in time.) Likewise, the health cost of the unhealthy food would not be incurred until the future, while the cost of not fulfilling a culinary desire was immediate.

The same concept applies to taxes and long-term portfolio management. The benefits of diversification and rebalancing aren’t immediately felt. The cost of tax payments is. So, it is very possible for an investor to let short-term tax decisions drive his long-term investing strategy, instead of focusing first on what makes the best sense from a long-term portfolio management standpoint.

This said, the payment of taxes reduces wealth. There are methods of finding a middle ground between minimizing annual tax liabilities and adhering to portfolio practices that have long-term benefits, however.

If you have both taxable and tax-sheltered (e.g., retirement) accounts, you can use both to adhere to a long-term strategy and minimize your short-term taxes. As much as is reasonably possible, use your tax-deferred accounts (e.g., a traditional IRA or a Roth IRA) for holding less tax-efficient investments and for following investment strategies likely to trigger tax liabilities. Use your taxable accounts for the more tax-efficient investments and investment strategies.

You can also adjust your investment strategies so that they trigger fewer taxable transactions. For example, rather than rebalancing when your allocations are more than five percentage points off target, widen the range to allow a 10-percentage-point variance. Similarly, if it looks like you will need to rebalance within the next few months, start looking for losses to harvest and/or allocate dividend and interest payments to cash to help fund the rebalancing.

The biggest thing to remember is that the optimal investment strategy is not one that generates the highest absolute return or the one the minimizes taxes the most, but rather one that you can continuously follow during both bull and bear markets to achieve your long-term financial goals.

More on AAII.com

The Week Ahead

First-quarter earnings season “officially” starts on Monday afternoon when Alcoa (AA) reports. Joining Alcoa will be fellow Dow component JPMorgan Chase (JPM) on Friday. Fellow S&P members Bed Bath & Beyond (BBBY), CarMax (KMX), Constellation Brands (STZ), Family Dollar Stores (FDO) and Fastenal Company (FAST) will report on Wednesday.

On the economic front, the minutes from the March Federal Open Market Committee will be published on Wednesday afternoon. Thursday will feature March import and export prices. The March Producer Price Index (PPI), March retail sales, the preliminary April University of Michigan consumer confidence survey and February business inventories will be published on Friday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year notes on Thursday.

AAII Sentiment Survey

Neutral sentiment is at highest level since December 22, 2011 in the latest AAII Sentiment Survey. The rise in neutral sentiment is occurring as both short-term optimism and pessimism are falling among individual investors.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.9 percentage points to 35.5%. This is the third consecutive weekly decline. It also puts optimism at its lowest level in a month. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 3.4 percentage points to 36.3%. As noted above, this is the highest neutral sentiment has been in more than 16 months. It is also the first time neutral sentiment has been above its historical average of 30.5% on consecutive weeks since October 4 and October 11, 2012.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.5 percentage points to 28.2%. This is a nine-week low for pessimism. The historical average is 30.5%.

The last time both bullish and bearish sentiment were below their respective historical averages on consecutive weeks was August 2 through August 16, 2012. The second-most-recent occurrence was on February 25 and March 4, 2010.

The declines in optimism and pessimism are not significant as both bullish and bearish sentiment remain close to their historical averages. While the major indexes continue to trade near record or multi-year highs, AAII members are mixed about what the next six months will bring in terms of market direction. Some members are encouraged by this year’s gains, while others fret that stocks are overbought and are due for a pullback. Also impacting sentiment are mixed views about the pace of economic growth and ongoing frustration with Washington.

This week’s special question asked AAII members which industries and sectors they like right now. Energy, including master limited partnerships, received the most votes, listed by 30% of respondents. Health care came in second with 23% of respondents favoring the sector, technology was a close third (21%) and financials came in fourth (14%). When we asked the same question last September, AAII members favored energy, health care, commodities and technology.

» Take the sentiment survey

AAII Asset Allocation Survey

March Asset Allocation Survey results:
Stocks/Stock Funds:
    59.5%, down 3.0 points
Bonds/Bond Funds:
    17.7%, down 1.5 points
Cash:
    22.8%, up 4.6 points

Asset Allocation details:
Stocks:
    31.8%, down 1.4 points
Stock Funds:
    27.7%, down 1.6 points
Bonds:
    5.3%, up 1.5 points
Bond Funds:
    12.4%, down 3.0 points

Take the survey »


Cash allocations reached a 16-month high in March, according to the latest AAII Asset Allocation Survey. Individual investors pulled money from both equities and bonds last month.

Allocations to stocks and stock funds fell 3.0 percentage points to 59.5% in March. During the past 15 months, equity allocations have not varied significantly, instead staying within a range of 58.8% (June 2012) to 62.5% (February 2013). The historical average is 60%.

Bond and bond fund allocations declined 1.5 percentage points to 17.7%. This is the smallest allocation to fixed-income securities since February 2011. It is also the 45th consecutive month that bond and bond fund allocations are above their historical average of 16%.

Cash allocations jumped 4.6 percentage points to 22.8%. This is the largest percentage of portfolio assets held in cash since November 2011. Even with the increase, cash allocations remained below their historical average of 24% for the 16th consecutive month.

The rise in cash levels comes as individual investors are grappling with two events. The first is the strong first-quarter performance for stock prices. While some AAII members are more optimistic about the short-term outlook for stocks, others fret that stocks are overbought and are due for a pullback. At the same time, this year’s upward move in Treasury yields and continued signs of economic growth may have caused some investors to reduce their exposure to bonds.

» Take the Asset Allocation Survey