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DAMODARAN: For Investors, The Goal Is Not To Minimize Taxes
At this point, it looks like capital gains taxes are going up tomorrow.
For all investors, the rate will climb to 20 percent (after holding at 15 percent for the past decade). For investors with more than $ 200,000, the rate will jump to 23.8 percent.
Aswath Damodaran, the legendary professor of finance at NYU’s Stern business school, has a new blog item on how he’s adjusted his portfolio accordingly.
His premise is simple: “The objective in investing is not to minimize taxes paid but to maximize after-tax returns” (holding pre-tax returns constant).
That’s why he ignored his first impulse, which was to sell the stocks he’d held for more than a year to save on taxes:
…the savings in capital gains taxes have to be weighed against the value lost by selling early, if the holding in question is still undervalued, he writes.
Here’s what he did:
I ranked the investments in my portfolio, based upon absolute capital gains and then revalued each of the five stocks at the top of the list, using updated information. The three stocks that were still under valued (based on today’s price and updated valuation) by more than 5% remained in my portfolio, whereas the two stocks that were under valued by less than 5% or were fairly valued (or over valued) were sold.
If you don’t have the time or the inclination to do a full fledged valuation, you can still ask yourself a question about your big winners: Would you buy the stock at today’s prices? If the answer is yes, you should be hold back on selling the stock, even though capital gains taxes are going up next year.
Damodaran also explains that too much trading and short-term thinking can prove costly from an after-tax perspective. He provides this handy chart showing the tax consequences of short-term stock flipping in the form of turnover ratio (the volume of a stock versus it’s value):
Investors with short time horizons generally pay more in taxes for two reasons: (1) their holding periods are too short to qualify their gains for long term capital gains, thus converting their price appreciation in ordinary income (with higher tax rates) and (2) the high turnover in their portfolios makes it impossible to have a cohesive tax strategy.
Bottom line, he says: “I may be simple minded when it comes to taxes but I think that the most effective tax management strategy for most investors is to have a long time horizon. “