The Silver Lining

January 12, 2016

Two thousand and fifteen was a challenging year for investors. Outside of some very large companies with high growth rates (Amazon and Facebook, among a few others), the majority of stocks in the S&P 500 ended the year with negative returns.

U.S. small cap stocks also suffered as did most international and emerging market stocks. Even a large portion of the global fixed income sector had disappointing returns with high yield bonds leading the way down.

Over the past few years, we have enjoyed broad based positive performance for most securities, but this year saw mostly broad based negative market performance. During years in which securities are mostly negative, there are actions that can be taken that help position the portfolio for improved results in the future and help reduce the pain of losses incurred on portfolio holdings.

While there was a fairly broad based decline among many different types of assets this past year, most of the losses were experienced in equity holdings. More stable assets like bonds probably ended the year with little changed. This outcome likely resulted in a typical portfolio ending the year with a different asset allocation profile than the portfolio held at the beginning of the year. As an asset class becomes underweight relative to other asset classes, it is helpful to re-examine the asset allocation targets and determine if the targets remain appropriate given the investing time horizon and risk profile of the investor.

Based on these factors as well as expected market returns, it is prudent to rebalance the portfolio to the desired overall equity and fixed income allocation. This generally means selling some of the better performing investments and using the proceeds to purchase more of the laggards. Rebalancing a portfolio periodically back to target allocation percentages can become a fairly simple strategy for a long-term investor to buy low and sell high.

Many market sectors sold off this year, most noticeably the energy and manufacturing sectors. When an entire sector is selling off, it generally means that plenty of good companies will get sold off along with those companies faced with more dire circumstances. While there may be a tendency to evacuate an underperforming sector entirely, a better approach is to identify the stronger companies that have been sold indiscriminately in that particular sector. Swapping out of weaker companies and into these stronger companies, even in weak economic sectors, will yield good results as the weakness in the particular sector ultimately subsides. Investors should keep in mind that last year’s losers may often perform much better the following year. A security or asset class that has lost a significant portion of its market value may very well be priced at a discount to the intrinsic value of its long-term prospects. The chart of asset class returns over the past 13 years provides visual evidence of this pattern.

We normally buy and sell securities based on their investment outlook, but sometimes it is useful to take advantage of tax regulations to help with overall household returns. The U.S. tax code helps investors by allowing taxpayers to utilize their losses to offset capital gains and taxable income. Selling securities to generate tax losses is called tax loss harvesting. Tax loss harvesting is the practice of selling securities in taxable accounts that are worth less than what the investor originally paid for them. The aim of harvesting losses is to offset recognized gains in investment securities with realized losses and use any remaining loss to offset up to $3,000 in ordinary income. Excess losses beyond the $3,000 limit may be carried over to future tax years.

Income and capital gains taxes take a big bite out of investor households. The top rate on capital gains is 20%, but the 3.8% Medicare surcharge on investment income for wealthy taxpayers brings the highest capital gains rate effectively to 23.8%. By generating losses to offset capital gains, a taxpayer can reduce their federal income tax liability by nearly $2,400 for every $10,000 in realized capital gains. With the top rate on ordinary income at 39.6%, the taxable benefit of offsetting $3,000 in ordinary income is just under $1,200 in reduced federal income taxes.

Especially after a market correction when many holdings have declined in value and asset allocation has been modified from target allocations, portfolios will require rebalancing to return to the intended asset allocation. Upgrading the quality of individual holdings and reaping tax-loss harvesting benefits can also be a silver lining in an otherwise challenging year in the markets.

AUTHOR:

MALCOLM BUTLER, JD