Taxes are a funny thing.
No one likes paying them.
Everyone does their best to minimize them when possible.
A dollar saved on taxes feels multiple times better than a dollar earned from a paycheck.
People hate paying taxes even more than they enjoy making money.
Yet when investing, paying taxes means you’ve won the game. Something you bought went up in price, giving you gains and enabling the government to take its cut.
And it stings because taxes are a form of loss aversion. It feels like something is being taken away from you.
I’ve had lots of bull market tax conversations with wealth management clients in recent years. The stock market boom has led to huge taxable gains for many investors.
The biggest gains tend to be seen in individual stock holdings. Some people put money into tech stocks that have gone vertical. Others have employee stock options with a lot cost basis.
These people recognize the need to diversify concentrated positions. The old adage is you concentrate to get rich and diversify to stay rich.
But many are hesitant to do so because it would require a large tax bill.
Advances in trading technology and fees have given investors solutions to this problem that didn’t exist in the past.
Direct indexing allows you to tax loss harvest at the individual security level. But if you have large enough gains and want to get out of your positions relatively quickly, direct indexing might not be able to create enough losses in time to solve your problem.
Enter long/short direct indexing. By adding some margin and shorting some stocks, you now have the ability to turn the tax loss harvesting dial up a notch which can help speed up the process of creating more losses to offset your gains.
These strategies aren’t perfect. They’re more complicated. They’re not for everyone. But they are another arrow in the financial planning quiver.
However, there are implications at play here that go beyond the numbers. Tax deferral strategies like this come with psychological challenges too.
My colleague Nick Maggiulli wrote a great post about these challenges called Living Rich to Die Poor. Nick raises a good point here:
As it generates more gains, it lowers your likelihood of ever selling these positions. Why? Because, in my experience, people hate paying taxes more than they like making money. As a result, you can end up stuck in the strategy.
This is by design. A levered long/short strategy generates lots of losses in the early years, but as markets (typically) drift upward over time, there are fewer and fewer losses to harvest. As a result, you end up with an increasing amount of unrealized gains.
I’ve seen firsthand how difficult it can be for certain individuals to enjoy their hard earned money. Creating a large tax deferral in such a short period of time can create a barrier to spending your money.
First world problems for sure but you have to account for enjoyment in your financial plan too.
Every investment strategy involves trade-offs and unintended consequences.
Sometimes even intelligent solutions can cause problems you didn’t consider.
Nick joined me on Talking Wealth to talk about tax-aware long/short strategies, when they actually make sense for investors, when minimizing taxes can actually hurt your financial plan, the tradeoff between maximizing wealth and actually using it and why the best strategy is often situational rather than one-size-fits-all:
Further Reading:
Tax Alpha
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