End-of-Year Investment Options and Tax Planning Strategies

Come Monday morning, I might jest about strolling into my boss’s office and demanding a pay cut to slip into a lower tax bracket next year. Of course, it’s absurd, but isn’t it akin to the financial world’s “Conventional Wisdom” (CW) for year-end tax planning? What about the long-term aspect of investing or the conviction behind a certain investment touted just months ago? Who came up with these strategies, and what drives them?

Clearly, numerous questions beckon answers. Yet, as investors, it’s essential to grasp that the ultimate aim of investing is to turn a profit—maximizing returns swiftly, legally, and within a low-risk framework. After all, the faster money rolls in, the more effectively it can grow through compounding. Or should we, following the “CW,” seek out as many losses as gains to evade tax implications? Would Zero Taxable Gain Investing be the only “smart” strategy? An article in The New York Times Money Section in December 2004 even hinted that Investment Professionals should purposely incur losses to alleviate tax burdens.

While your Financial Professional may offer astute tax advice, for sound investment guidance, only professional investors (not accountants, attorneys, stockbrokers, or financial planners) should be consulted. CPAs may appear prudent if they reduce your tax liability, but many focus too narrowly on the calendar year, disregarding the emotional and cyclical nature of investment markets. Consider last year’s Merck, for instance. It’s nearly doubled in market value since the advice to sell it last November—quite unexpected, isn’t it? Why not buy more of it (or similar quality losers) instead of selling? Fortunately, not all professionals advocate losing money. In my thirty years of working with countless Accountants and advisors, scarcely a handful have suggested clients should accept losses on fundamentally sound securities, be it Equity or Fixed Income. Imagine if you’d taken your dot-com profits in ’99, invested in undervalued profit-making companies, and accepted the taxes. Value companies didn’t crash; they’ve rallied for nearly seven years!

The primary consideration in contemplating a capital loss should be the investment’s economic viability, not just your tax position. A cornerstone of The Working Capital Model (for investment portfolio management) is to shed the weakest security in a portfolio each time its market value hits a significant new “All Time High” profit level (ATH). Definitions may differ:

1. Profit equals Total Market Value minus Net Portfolio Investment.
2. A “weak” security could be one no longer rated Investment Grade by S&P, delisted from the NYSE, ceased paying dividends, or no longer profitable. Income securities with payouts significantly below average (or unsustainably high) could also be culled at an ATH. Securities whose market value has dropped considerably for no discernible reason (apart from recent news or shifting interest rate expectations) are affectionately dubbed “Investment Opportunities”—what you seek when reinvesting profits, like last year’s MRK. Switching between strong asset classes and weaker ones as a “hedging strategy” or speculative move driven by greed is merely an attempt at market timing, not a sophisticated adjustment to asset allocation, which should always be based on personal factors, not directional speculation in asset classes (Equities and Income Generators).

So, what if a new portfolio ATH is reached in February or August rather than November or December? (Note that the financial community preaches tax loss strategies only in the last calendar quarter.) Should all weak holdings, even those purchased a few months ago, be offloaded simultaneously? Managing your portfolio demands disciplined application of consistent rules and guidelines, and every manager will develop their style. But in a high-quality, properly diversified, income-generating portfolio:

1. Weak holdings are typically few.
2. The likelihood of exiting with only minimal losses is real.

Bear in mind two fundamental investment truths: There’s no such thing as a bad profit, irrespective of tax implications, and rationalization aside, there’s no such thing as a good loss. So, if a loss must be taken due to an ATH in February, accept it on the one security (just one) showing declining fundamentals (and remember, a Merrill Lynch/CNN/CFP opinion doesn’t constitute a fundamental). If there are none, well done!

Profits are the aim of investing. Few admit how infrequently they’ve enjoyed them or how often they’ve watched them vanish in a correction. Similarly, most financial professionals urge clients to let profits ride, especially at year-end. The CW prophets insist these profits will linger until next year, postponing dreaded taxes! (Remember how well that worked at the end of ’99?) Don’t assume anyone knows what’ll happen this time around the rally pole, especially with those absurdly priced ETFs, cobbled together with the same haste as the dot-coms. Always take profits too soon—you can’t go broke that way!

So, come Monday morning, I’ll:

1. Inform my accountant I’ll help reduce his tax burden by not paying him.
2. Continue viewing investing in cyclical, not calendar, terms.
3. Limit my tax liability by how I invest, not by taking needless losses.
4. Keep making as much money as possible, as quickly and safely as possible.
5. Reach out to the media, my political representatives, and anyone else who’ll aid in the fight to abolish taxation on all investment and retirement income.

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