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TAXES STUNT PORTFOLIO GROWTH ... FALSE

You hear the advice to limit stock turnover because selling a stock triggers capital gains tax leaving you less principal left to reinvest. This smaller investment generates a smaller return and portfolio growth is stunted. But how true is this? Does this qualify as "letting the tax tail wag the investment dog"?

There are two situations where it is undoubtedly true. First, when a stock is sold in order to buy another with the same, or even worse, expected return (e.g. for rebalancing), nothing (except possible reduction in risk) is gained and tax is needlessly prepaid. Second, when the payment of tax can be deferred until after death, you will receive larger dividends from the original investment. You will not care about the eventual tax after death.

This leaves the majority of situations, where you can see a higher expected return from a replacement stock, and you know the unrealized tax will be paid in some future, regardless. Use your own variables in the example following. Your calculator gives you the Future Value calculation. Chances are that even a 1% incrementally better return will justify switching stocks.

Take a scenario that starts with a portfolio worth $200,000 that has doubled in value (an unrealized capital gain of $100,000). Assume the top 45% tax rate applied to capital gains at 22.5%. Make the assumption that the replacement stock will return 1% more than the old stock. Assume that the maximum deferral of tax will be ten years before you would be 'forced' to liquidate anyway, even if you don't sell now. How will two portfolios compare when one triggers tax today in order to buy a new stock, and the other stays invested with a lower return?

Should you make it a strategic policy to hold a stock forever? This idea was put in many people's heads by an article in a Canadian DIY-investing magazine. They claimed that a random selection of large-cap stocks purchased x years ago and HELD, not only did as well as the benchmark, but outperformed WIDELY. The back-testing to support the claim was a joke and invalid on many fronts, starting from even getting the benchmark's return wrong.

But investors believe what they want to believe. There are now 30-year-olds who have decided they will buy blue-chip dividend stocks and hold them for their lifetime - planning to not even sell to pay for medical care in their last years of life. They figure they don't need tax shelters like RRSPs because they will never pay tax. They figure their income in retirement will be higher with this strategy because their dividend yields will be greater (on purchase price). There are huge problems with this strategy.

• Blue-chip stocks no longer really exist. They used to have monopoly powers from government, but now even utilities with regulated divisions also manage unregulated divisions.
• Business entities are constantly morphing. Some get bought out, others buy business lines that are not the blue-chip you started with.
• Should you really PLAN on your life being smooth sailing, without ever losing your job or taking a sabbatical and needing cash, without ever finding it necessary to help out a friend or family, without ever needing medical care in your last years, without ever plundering the bank to pay of travel when retired, without your spouse needing home-care while recovering from cancer? Life is just not that predictable.
• Management and competition are always changing. Great companies wither and die. A 30 year timespan is almost unthinkable. Things change.
• Although capital gains accrues without tax, the dividend stream is taxed each year. In the lowest tax brackets this is a negative tax and may be beneficial, but what happens when your wages have risen so that it becomes a positive tax? You cannot move the asset into an RRSP without triggering all that deferred capital gains.
• Allowing unpaid taxable capital gains to accrue has the result of creating an added burden when bad things happen and cash is needed ... exactly when you don't need more problems. The opposite is also true. In 2008 a lot of people retired people learned what a wonderful thing capital loss carry backs are. The tax recovery in that year of poor returns was enough to fund a year's expenses in many cases. But you had to have paid your taxes in the good times for that to work.
• From a Behavioral Finance view, you should avoid behaviors that you know will trigger bad decisions. Comparing a certain tax bill to an uncertain higher return with another stock is a hard emotional decision. Regardless of the math, you are likely to NOT sell.
• The decision to not ever sell has a cost. It is a conceit to think a static, frozen portfolio will earn benchmark returns. It will underperform. The size of the tax bill locks you into bad decisions. You are setting yourself up.

Before you make it a policy to HOLD FOREVER, play with some number in this spreadsheet. The example shown below shows that it does not take much of an increase in expected rates of return, to make paying your taxes preferable to holding forever. The values of two portfolios with the different assumed tax treatments are tracked. At each year end the HOLD portfolio is valued as if it had been eventually sold and all the accrued tax paid. The difference in value is shown on an annualized rate of return basis.

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