The Taxman Says, Stay Invested

Taxing Matters I have never been more wary of the U.S. stock market. The perils are obvious. The economic expansion is so very old; the Treasury yield curve is (moderately) inverted; the Bundesbank expects a German recession; and the S&P 500's cyclically adjusted price/earnings ratio is almost 30. It seems that corporate earnings will be squeezed, but stock prices have not anticipated such an event.

My instincts urge retreat. However, psychological considerations and the IRS suggest otherwise. Market-timing is a mug's game, particularly in taxable accounts.

It's fine to make trades in taxable accounts after securities have declined, when there's no penalty for booking gains. Such is not the case today, however. Equities have enjoyed a nonstop ride, thereby propelling even dullards' portfolios. Every stock (and stock fund) that I own currently sells above its purchase price.

Which means that any trade that I make will generate profits, those profits will generate taxes, and next year, those taxes must be paid. That can't be helpful.

Death Is Inevitable, Taxes Are Not For one, that tax bill is not inevitable. Even if my holdings continue to appreciate, I could evade the IRS by bequeathing my equities at my death, thereby "stepping up" their cost bases. Those receiving the securities will book them at the transfer date's prices, not at my acquisition costs. Admittedly, that won't directly benefit me, but it will help those whom I care about.

Nor must those taxes necessarily be relinquished if I sell my stocks while alive. What went up could well go down. The stock that I unload today, thereby booking a gain, may eventually decline, falling below my purchase price. Should that happen, I will have sent the IRS an unnecessary gift in spring 2020. Simply biding my time would have made the tax liability disappear.

It will be objected that this point is deeply foolish. (I have heard such rumblings before.) My complaint, after all, is that I might sell a stock high, rather than wait and sell it low. That does sound remarkably stupid. However--and here's the critical point that underlies this entire column--I must do something with the money that I have just raised.

Reinvestment Risks One option is to keep it as cash, forever. That is a terrible idea, unless stocks perform badly for a very long time. However, it is a surprisingly easy error to make. It is because of such mistakes that market-timing mutual funds no longer exist. Some were adept at dodging downturns. None, however, succeeded at putting that money back to work. The market-timing funds sat on their cash, and then sat some more. When they looked up, stocks had rebounded well past their previous highs, and yet they still held that cash.

Another choice is to place the proceeds into more-conservative investments. That approach, one might think, delivers the best of both worlds. The investor is shielded, albeit not fully protected, against a stock-market crash, while not facing the problem of reinvestment. But ultimately, this is but a milder version of the cash problem. The trade positions the portfolio more cautiously, and future such trades will do so further. The investor's stock position is declining, permanently.

What must happen, unless I am to alter my portfolio's asset allocation, is that those monies be placed back into equities. Assume that I do so skillfully. Either the downturn does arrive, and after it wreaks its havoc, I reinvest; or there is no slump, but I avoid the bear trap by recognizing that the potential danger has passed, and I repurchase equities. Either way, I have restored my original asset allocation.

The Bottom Line Now comes the additional problem. These sell-and-buy round trips cause tax frictions. It is sometimes believed that whether one pays capital gains taxes now or pays them later is immaterial, because ultimately the tax bills will match. However, that is incorrect. Money possesses a time value, and that time value is maximized when the security's sale is delayed.

A brief example will illustrate. An investor in a taxable account buys a stock that costs $10 per share, sells the stock when its price reaches $15 per share, pays taxes on that profit, then reinvests the remaining proceeds (that is, after the taxes are paid) back into that security. The stock rises further, to $20 per share, at which point the investor closes out the position.

The math for an initial $10,000 investment, with a 20% capital gains tax rate, works as follows:

1) Purchase 1,000 shares, at $10 each

2) Sell 1,000 shares at $15, thereby receiving $15,000

3) Send $1,000 to the IRS (20% of the $5,000 profit)

4) Reinvest the remaining $14,000 into the stock, at $15 per share, thereby receiving 933.3 shares

5) Sell 933.3 shares at $20, thereby receiving $18,667

6) Send $933 to the IRS (20% of the $4,667 profit)

7) Final proceeds = $17,733

Had the investor not made that intermediate trade at $15 but instead held the stock as it moved from $10 to $20, then closed out the position at $20, the math would be:

1) Purchase 1,000 shares, at $10 each

2) Sell 1,000 shares at $20, thereby receiving $20,000

3) Send $2,000 to the IRS (20% of the $10,000 profit)

4) Final proceeds = $18,000

The missing $267 disappeared from the tax friction. It represents cash that could have been invested, but was not, because it had prematurely been diverted to the IRS.

(Of course, one can counter that the investor in the first case didn't send those monies to the IRS. That first IRS payment of $1,000 came from another account, which means that the investor placed the full $15,000 back into equities, and thus the final proceeds match for the two cases. But the argument is bogus. One way or another, that $1,000 disappeared from the investor's portfolio. It no longer earns a return.)

Thus, I will maintain my current position and take what lumps might be coming. If I knew, with certainty, that my fears were warranted and that equities will soon tumble, then of course I would sell my equities. (Or better yet, buy stock-market put options.) But in the absences of such knowledge, best to play the odds and avoid unnecessary costs--as well as the psychological challenge of eventually putting any cash that I raise back to work.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.