Wag The Dog Stock Investing

The dog and tail people are at it again. DATs, I call them. These are the financial advisors who say, "Don't let the tax tail wag the dog. Taxes should not be your primary reason for buying or selling something."

There are a lot of DATs. I estimate 320,000 people have, in the past month, mentioned tax tails in a canine context.  (WSJ subscribers: Find the dog tail in today's online edition.)

The DATs are wrong. Taxes should be at the top of your mind when you do a trade—in a taxable account, that is. In a tax-deferred IRA, of course, trading doesn't affect your tax bill.

Taxes are one aspect of investing that you can control. You can add tens of thousands of dollars to your retirement stake by understanding tax rules. You don't have to be lucky. You don't have to be a genius. You just have to know a few principles, like the ones that say you should let winners ride and you should harvest losses.

Can you add value by figuring out which stocks are going to go up? Or by sidestepping losses? Probably not. The average investor is no more skilled at stock picking than the average monkey.

Perhaps you have persuaded yourself that you are among the exceptions. There's a small chance that you are right. There's a high probability that you are in the large population of Americans (mostly male) who overestimate their stock-picking ability.

DATs have stories that go like this:

"One of my clients got into Blackberry at $12. He rode it up to $93. I told him the stock was getting ahead of itself and he should take some money off the table. He didn't want to pay the capital gain taxes. Now look where he is."

So? What about the guy who bought Apple Apple at $12, saw it shoot to $60 and decided it was overpriced? He didn't want to pay the taxes. He still owns the stock.

Suppose you have two stock positions worth $10,000. You bought one at $11,000. You bought the other for $6,000. You need $10,000 of cash. My advice: Sell the loser. You now have a $1,000 capital loss that you can use to lower your taxes. Hang on to the winner until you die.

At which point the DATs will come out of the woodwork and say that my advice will have investors buying at tops, selling at bottoms and missing the rebounds.

With this, DATs are clinging to a belief that stocks that have fallen have a particularly good chance of going back up, while stocks that have risen are particularly likely to fall.

To which I answer: If this is true, why are you wasting your life dispensing tax advice? You could start a hedge fund. Buy the 300 stocks that went down the most last year, and short the 300 that went up the most. You could make maybe a billion dollars, with no effort.

If individual stocks don't regress to a mean, still the market as a whole might have that tendency. One could argue that the market is likely to rebound after a bad stretch, or to pull back after a decade of abnormally high returns.

So there is some validity to the warning that avid loss harvesting could have you exiting stocks when they are cheap. There's an easy cure for this problem. If you sell for a loss, buy something else. You could sell three gold mining stocks and then buy a gold-mining fund. Sell Chevron Chevron and buy Exxon. If you are really in love with the original positions, wait 31 days (as mandated by the tax code's wash sale rule) and go back to what you had.

Rebound regret occurs when the stock you sold for a loss recovers during the month you're on the sidelines. This is a particularly painful condition. You can minimize the risk of suffering it by doing your loss harvesting in batches. Stochastic loss harvesting, I call it.

Let's suppose you have six stocks that have cost you money. (You may be sitting on nothing but winners at the moment, but the day will come when you are looking at a column of red ink.) Sell A, B and C, and invest the proceeds by doubling up your positions in D, E and F. Thirty-one days later, sell your old positions in D, E and F and invest in A, B and C.

Maybe DEF will underperform ABC during the wash-sale wait, but probably not by much, and of course the reverse phenom is equally likely. If the market stays flat you'll be back where you started but you'll have six capital losses to claim.

Stop listening to the DATs. Spend more time thinking about how taxes affect your results, and less time trying to outguess the market.

Here are some articles about how smart investors lower their tax bills:

How Retirees Pay Zero Taxes

Smart Kiddies Duck Tax

A Roth Conversion Formula

Young Google Google Employee With A Clever 401(k) Move