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How often should you tax-loss harvest?

Many investors with taxable accounts (and advisors managing them, for that matter) tend to wait until year-end before looking for tax-loss harvesting opportunities. This can be costly for the investor, as unrealized losses that are available throughout the year may disappear by December.

As with most areas of investing, it is generally advisable to have a tax-loss harvesting plan in place prior to implementing a portfolio. This will ensure that discipline is maintained throughout the investment process.

So what would be a good “rule of thumb” for harvesting losses?

In Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan, he suggests two hurdles that should be met before engaging in tax-loss harvesting:

  1. There should be a minimum absolute dollar loss on the security of $5,000
  2. There should be a minimum percentage loss on the security of 5%

For example, suppose an investor purchases $100,000 of iShares S&P/TSX Capped Composite Index Fund (XIC) in their taxable account on January 2, 2012. On June 22, 2012, the value of XIC has dropped to $95,000. Should they harvest the loss?

Answer: Both hurdles suggest that the loss should be realized. Therefore, XIC should be sold and a similar (but not identical) security should be purchased with the proceeds.

Hurdle 1 has been met: There is an absolute dollar loss of $5,000:
$95,000 - $100,000 = |-$5,000| = $5,000

Hurdle 2 has been met: There is a minimum percentage loss of 5%:
[($95,000 / $100,000) – 1] = -5%

As with any rule of thumb, there are going to be exceptions. For example, suppose you have a net capital gain from 2009 that will expire if you don’t offset it with a net capital loss by the end of 2012. In this instance, it may be appropriate to harvest a loss this year even if both of the above hurdles are not met.

If you are a do-it-yourself investor with taxable accounts, ensure that you are checking periodically throughout the year for tax-loss harvesting opportunities. If you work with an advisor, ask them if they have a disciplined process in place to take advantage of these opportunities. If they look puzzled, consider finding another advisor.

By: Justin Bender | 4 comments

Sell in May and Go Away?

Over the past 30 years, Canadian investors would have been better off investing in bonds than in stocks; not only did bonds have higher returns, they also had considerably less risk (see table below).

January 1982 to December 2011

Source: Dimensional Fund Advisors

This has led some investors to search for alternative strategies that they believe will help them beat the markets over time. One such strategy that has been gaining attention is the “Sell in May” strategy. Basically, an investor would allocate 100% of their portfolio to stocks from November to April of each year. Starting in May, they would sell all of their stocks and place the proceeds in cash (i.e. T-bills) – in November, the cycle would start all over again.

In the table below, I have created a portfolio to back-test this strategy, and compare the results to a diversified balanced index portfolio.

“Sell in May” Portfolio

This portfolio is fully invested in the S&P/TSX Composite Index from November to April of each year, and then fully invested in Canadian One-Month T-Bills from May until October of each year.

“Couch Potato” Portfolio

This portfolio is invested as follows and rebalanced annually:

  • 40% DEX Universe Bond Index
  • 20% S&P/TSX Composite Index
  • 20% S&P 500 Index
  • 20% MSCI EAFE Index (net dividends)

January 1982 to December 2011

Source: Dimensional Fund Advisors

Although the “Sell in May” Portfolio outperformed the “Couch Potato” portfolio slightly (10.80% versus 10.13%), it did so at the cost of higher volatility (9.85% versus 8.53%) and resulted in identical risk adjusted returns (Sharpe ratio of 0.49).

I’ve also illustrated the historical rolling 3-year standard deviation of both portfolios in the chart below – as you can see, the extreme spikes in volatility of the “Sell in May” Portfolio could cause even the most seasoned investor to lose their cool.

Rolling 3-Year Standard Deviation: January 1983 to December 2011

Source: Dimensional Fund Advisors

Other issues to consider with the “Sell in May” strategy

  1. Investors who require withdrawals from their portfolios may not be able to raise the necessary cash without selling stocks.
  2. Buying high and selling low could be an ongoing result of this naïve strategy.
  3. No evidence to suggest why this strategy would do well in the future.
  4. After-tax returns for a taxable investor could be much worse than expected; constantly selling all of your equities each year could result in significant capital gains tax liabilities.
  5. 100% allocation to equities at any time of year could result in devastating losses.

For most investors, finding an asset allocation that they are comfortable with and sticking with it (rebalancing occasionally) will most likely give them the best probability of a successful investment experience.



By: Justin Bender | 0 comments

Should you invest your entire portfolio in DFA’s new “fund of funds”?

With the introduction of new balanced funds from Dimensional Fund Advisors (DFA) last year, it begs the question on whether this “one-stop-product” is appropriate for the average investor (for a recent blog on this product, please read Dan Bortolotti’s blog).

From my perspective, advisors who are not even considering this alternative for clients holding only modest sized non-taxable accounts (such as RRSPs and TFSAs) may be doing their clients a disservice, for a number of reasons:

Low-cost, relative to the industry average
For the cost of a single trade, your client would be fully invested in a globally diversified portfolio for a relatively low ongoing cost (1.70% MER compared to the Average Global Neutral Balanced Mutual Fund, at 2.23%) – some fee-based DFA advisors may charge even less. On a $100,000 investment, this would amount to an annually savings of approximately $530.

Ability to contribute monthly at no cost
Mutual funds, unlike most ETFs, have the ability to automatically invest additional amounts as well as reinvest dividends. This can significantly cut down on the trade costs of reinvesting cash into numerous portfolio holdings.

Automatic rebalancing
There is no need for you to rebalance the portfolio – all of this is done (arguably, much more cost effectively) by DFA. You must still ensure that the overall asset allocation is still appropriate, given your client’s unique willingness, ability, and need to take risk.

Investing in balanced funds may help investors avoid “The Behaviour Gap”
Studies have shown that investors in balanced funds stay invested longer (and earn higher returns), relative to investors who jump in and out of asset classes. This benefit cannot be understated.

For our clients in Toronto who hold only registered assets, I would not hesitate to recommend these products as a viable long term portfolio solution. If they hold assets in non-registered accounts, I would be less inclined to construct an “all DFA” portfolio (more on this in a future post).

Sources: Dimensional Fund Advisors, Morningstar PALTrak

By: Justin Bender | 1 comments