Tax Loss Harvesting

Taxes are a complicated topic and when I discuss taxes on this blog I start with the caveat that you should do your own research and each situation is unique.

All else being equal, stocks in the name of the kids, up to a certain point, are tax favored. Due to the small size of the portfolios and the fact that the kids don’t have a lot of income coming in from other sources, they generally are in low tax brackets.

If you ignore the impact of commissions (buys and sells) one strategy would be to “step up” the basis of stocks every year where you have sales for losses by selling some winners. At the time when the beneficiary starts to sell the stocks in the portfolio to fund some useful purpose (like a down payment on a home), the selling price at the time they sell will be compared to the cost basis (what we paid for it) and then they would have a gain (hopefully) or a loss (if it is worth less than we paid for it). Given that these portfolios have an expected life of greater than a decade hopefully they should be worth more when cashed out then the purchase price.

Since tax losses don’t have much financial value to kids in low tax brackets without other income, a strategy every year when you sell stocks for losses (because of poor future performance predictions, such as with Nokia which was sold across the portfolios) is to look for stocks that have appreciated when you don’t see a lot more gains on the horizon and sell the stocks with gains to “net out” against the losses. Then, when you re-invest the proceed from the stocks that have gained, your tax basis will be equal to the higher amount.

In future posts I will go through the examples and I will be watching this in December because I have losses in 2010 from sales of about $800 in portfolios 1 and 2 and $500 in portfolio 3 and some appreciated stocks. I won’t just sell appreciated stocks for tax reasons, however, if I think they are still going to go up because I don’t want tax policy overriding investment decisions. But if I think a stock has had a good run, “stepping up” the basis by selling winners to match losers (since I can’t use the tax loss) makes sense.

Portfolio Three Update December 2010

Portfolio Three is on its 4th round of annual investing, meaning that it is a bit older than 3 years. This portfolio started during one of the most tumultuous times in the stock market, at least during my investing lifetime.

Total investment in this portfolio is $6000, with $2000 from the beneficiary and $4000 from me. In 2007 we sold China Mobile during what looked like a peak (still is far below that price, so it was a peak to date) but then got clobbered in 2008. With only a few stocks in the portfolio, it is at risk of total performance if even one stock does badly, and Nokia (NOK) just plummeted and frankly, like with portfolio two, we didn’t pull the plug on that stock soon enough. NOK just let its lead in mobile technology slip away when it missed the iPhone and next generation of smart phones and owning a large share of commodity phones with low margins won’t cut it. Also for those that view dividends (high dividends) as a path to wealth of course as the stock plummeted the dividend went down with it; you need earnings to support that dividend in the first place.

Recently with all that we are finally about back to break even; the portfolio is worth about $5900 (out of an investment of $6000).

Recent investments in overseas companies with ADR’s like Siemens (SI) and more recently a Canadian Bank (CM) and a Chinese oil company (CEO) have done well in the stock market run-up. Since most every issue has gone up (but the Chinese oil stocks in particular) it doesn’t take a genius to do well with the rising tides but it does feel good to get within a hair’s breadth of break even in this portfolio (as in “mattress status”, comparing against what would happen if you put the money under your mattress, a sad benchmark but relevant in these times).

With 5 stocks, the portfolio is still subject to large swings due to performance of a single stock, and we will watch them and not let them fall like we did with NOKIA, lesson learned there.

Another good thing about this portfolio is that we are able to do no-commission stock buys and sells, and there is not an annual fee for having the portfolio. Not having these charges adds up over time (they are essentially subsidized by my other accounts at the provider, which is fine with me).

Update on Portfolio Two Performance

Portfolio Two is my second longest portfolio and has been running for 6 years.

Portfolio Two started when the stock market was in rocky times and has finally climbed above break even, with a total investment of $10,500 and a value of $11,403. The portfolio has 11 stocks and thus is reasonably well diversified. Big winners (that we kept) include Exxon Mobil, Siemens and China Petroleum (SNP). In the past we had some major gains on sales for BHP and China Mobile, and some major losses on Nokia (just recent), Cemex and ICICI Bank. I should have sold Nokia sooner I won’t wait for that big of a loss when I see future declines before selling.

This portfolio benefits from the fact that now commissions are effectively zero on buys and sells since I am using my “free trade” allotment on this portfolio; this probably saves $60-$80 / year which adds up over time. Fees are also effectively zero.

This portfolio seems to be in a good place with regards to a balance between US and foreign companies (since the swing in the dollar significantly impacts values, and most economic growth is overseas) and we will watch the stocks here and look for potential sales of losers or opportunities to sell high for winners.

Portfolio Three Performance Updated July, 2010

Portfolio three has been in existence for three years, during one of the roughest and most volatile stock market periods. This portfolio is worth $3539 and dropped about 9% during the quarter, which is mostly in line with US indexes. This portfolio has only four stocks, meaning that changes in individual stock prices will have a disproportionate impact on overall performance.

Over the three years of portfolio life this portfolio has lost 21% of its value; $3000 was invested by me and $1500 by the beneficiary, for a total of $4500, against a current value of $3539 above. The annual performance is about -11.5% / year.

This portfolio can be downloaded on the right side of this page, updated for July 2010.

While all losses are painful and teach real-world lessons the beneficiary has still more than doubled their initial investment and it is good that the investment plus match by the fiduciary is 2x their investment in order to provide a buffer for the swings of the market.

Of the stocks in the portfolio, like the others it is suffering with Nokia (NOK) that I am strongly considering selling since they have not been able to fix their core business to date and are getting killed in smart phones. The other three holdings seem reasonable – 2 are majors (Wal-Mart and Siemens) and Urban Outfitters is smaller which means more upside for growth and has zero debt and is managed very reasonably for our difficult environment.

We will continue to invest over the years and it will become more diversified as the number of stocks being added increases, which will make portfolio performance swing less period to period relative to the indexes. With only 4 stocks if one tanks (Nokia, in this instance) it is difficult to recover.

Portfolio One Performance Updated July 2010

Portfolio One is my longest lived portfolio. This portfolio has been building up for nine years, and has a 3.1% return over that period. You can see the detail behind this portfolio as of July 2010 on the right sidebar.

We certainly were hit during Q2 2010, a time when US indexes generally lost about 10%. The balance as of March 2010 was $17,500 and now it is about $15,500, a loss of ($2000 / $17,500) = 11.4%. The loss was greater than the US indexes because the dollar strengthened against the Japanese Yen, the Euro, and the UK Pound during this time which further hurt some ADR’s in this portfolio even harder than the drop in the valuation alone.

This portfolio contains 15 individual stocks, with investments in each stock from a low of about $275 to about $1800, although the average is around $1000. At 15 stocks this portfolio has some reasonable diversification and should be expected to perform roughly in line with the overall indexes, give or take some for performance.

Out of the stocks in this portfolio I am most tired of Nokia. Nokia has a large percentage of the world’s cell phone market but is a dog at smart phones and is trying to re-invent itself. This reinvention has not been going well and I am about out of patience, likely will want to dump this stock as part of the new purchases to make during August, 2010.

I updated performance on the stocks we sold and generally do not have too much remorse for those sales based on their price today. In the past I sold some stocks when I thought they became over valued to try to take some of the risk off the table but as always there is reinvestment risk since you have to put that money back to work someplace else.

Portfolio Three Performance – Three Rough Years

The third portfolio has a life of three years. These three years coincided with many of the markets toughest years and thus the returns on this portfolio have been the lowest of the three so far.

A total of $4500 has been invested in this portfolio over three years, and the current value is $3752, for a loss of $747. This represents a 17% loss, or an annual loss of approximately 9%. The beneficiary has invested $1500 and the custodian $3000, so at least the trustee is doing well with a value of $3752 vs. an investment of $1500.

This portfolio had one decent winner, China Mobile (we sold before the big drop), and two tough losses; one on ICICI bank (ticker IBN) from India which was sold at the peak of market turmoil (and since regained some of those losses) and also Nokia (NOK), which had losses and cut their dividend but we continue to hold.

With only 4 stocks in the portfolio (2 until recently) any portfolio in the early stages with this few stocks is subject to market gyrations. Portfolio Two now has 10 stocks and Portfolio Three has 15 stocks so they at least have more diversification across markets (generally 10 stocks means that you have decent diversification, as a “rule of thumb”).

Investing is a long term game and played with real money; so when you start investing in a bad market it can be stomach turning at times, especially for kids who see this as “real” money since they earned and saved their portion themselves. Given the time horizon of these trust funds in makes sense to stick with the volatility and continue to watch the markets and keep going rather than pulling out and putting the money into plain vanilla investments.