The Strategy Will Slow Down. While I have thus far generated a decent amount of tax losses as set out in Part 3, the strategy will eventually lose steam. For example, let’s say you start by purchasing two shares of stock, X and Y, for 10 each; a portfolio whose value is 20. Let’s say X goes up in value by 5 and Y goes down in value by 5. So you sell Y for 5 and buy Z. Now you have a portfolio of X, which is worth 15, and Z which is worth 5; a portfolio whose value is still 20. However, when you started, you had two stocks who were at market and both had arguably equal chances of generating a loss. However, after Y lost value and you replaced it with Z, now X stock has a value of 15 and a tax basis of 10 and Z has a value and tax basis of 5. Because X is at a gain, the ability of the portfolio to produce losses will decrease. This effect is generally worse in a bull market, but, in most cases, you’d probably very happily trade the pre-tax income you’d get from a bull market for any tax losses produced by a bear market.
You can obviously keep the strategy going by pouring more money into it—either from your own cash reserves or leveraging it up, but I have to imagine that your resources are finite.
One additional project to think about is how would one go about computing the rate of decay on this strategy. I would imagine that this is something that is calculable taking into account certain assumptions about market volatility and the size and composition of the basket. That’s a bit beyond my skills, however.
Disincentive to Dispose of Gain Assets. Another aspect of this strategy is that you end up building in gain on the stock that you held and the tax advantage is obtained/maximized by holding onto that stock. For example, again, let’s say you invest in stock X and stock Y for 10 each. Stock X goes up in value by 5 and Y goes down in value by 5 (you trigger the Y loss by selling Y and buying Z). While you now have a realized loss of 5 on the Y shares, you have an unrealized gain on the X shares. Assuming you want the tax advantage, you can’t sell the X shares right away. This can be problematic if, for non-tax reasons, you need to dispose of the X shares.
In my current strategy, this doesn’t really bother me as I intend to hold onto these assets for a long-term anyway, but you never know what life will send your way.
Saving asset management fees. One advantage I did not point out is that most mutual funds that you invest in have asset management fees—some more and some less. I didn’t calculate the benefit of avoiding these fees. I believe it’s technically implicit in my calculation of a “hypothetical” alternative investment in SPY shares. There may be other hidden benefits/costs that are also implicit in this calculation as well but this is the main one that jumped out at me.
Target More Volatile Stocks. One thing that I mentioned in an earlier post is that I target stocks that have low bid-ask spreads. I think a lot of factors go into determining, including the liquidity of the stock (it’s trading volume), its volatility, its price, etc. I have been targeting stocks with low bid-ask spreads because it’s a somewhat verifiable cost and I wanted to keep that down for obvious reasons.
However, one factor alluded to above, volatility, would likely enhance the tax strategy. A nerdy way of defining volatility is that is the statistical measure of the dispersion of returns for a given security. A non-nerdy way of defining it is high volatility stocks have prices that move a lot more than prices with low volatility. Intuitively, it makes sense that higher volatility stocks would generate more opportunities than lower volatility stocks. Say you invest in X and Y and they are low volatility stocks—X may go up 1 and Y may go down 1, but that may not be a lot of juice for your tax strategy. However, two higher volatility stocks may go up/down by 10. Over a large enough portfolio, I would think a high volume portfolio can probably be managed down to the same overall risk as a low volatility portfolio, since statistically the ups-and-downs would tend to cancel each other out. Therefore, it may make more sense for me to target high volatility stocks in order to get more tax bang for my buck.
Just looking at my own portfolio, I looked at the volatility of the stocks I currently hold and the stocks that I have sold. In finance, beta is the measure of volatility and it compares the security to the market as a whole. A beta greater than 1 suggests that the stock is more volatile than the market and a beta less than 1 suggests the stock is less volatile than the market.
Note that my calculations are very rough and the beta that I identified for stocks was based on google finance listed beta and the beta I pulled was not contemporaneous with my actual trading. Therefore, take this with a grain of salt. However, the data does fit with the general notion that higher volatility stocks gave me more tax benefits. In general, the stocks I sold had, on average, a beta of 1.091 and the stocks I retained had, on average, a beta of 0.874.
Does this mean I should target stocks with higher beta? Well, the only issue is that, all other things being equal, I think higher beta stocks also tend to have higher bid-ask spreads. But, it’s also true that bid-ask spreads are determined by lots of factors and not just volatility. It’s entirely possible for a more volatile stock to have a lower bid-ask spread due to those other factors. Therefore, I think on a go forward basis when I purchase/replace stocks I’m going to attempt to focus on stocks with higher beta, but still trying to keep the bid-ask spread reasonably low.
Further updates. Assuming I don’t grow tired of this blog, I will provide further updates on this strategy from time-to-time (maybe).