Investors' tendencies toward self-harm are well known. We exit losing positions to chase winners, and we shift into trends after years of outperformance, virtually assuring we've missed the upside. We also tend to equate percentage gain with dollar gain, although the two are only partially linked.
Most investors I know would prefer a wowing 5-year set of annual returns like +18%, +18%, +21%, +20%, -21% to a boring +10%, +10%, +10%, +10%, +10% any day. The simple average of the wowing set comes to +11.2% despite underperforming the 10% set in actual dollars earned. This is due to compounding; the weight of the 21% loss in the fifth year eludes the eye, but the glittery returns entice!
Along with mental miscalculations like these, today's zero commission landscape gives some investors the perceived green light to chase anything flashy. But the friction of the process is far greater in other ways. I have heard tales of meme stock investors with $10,000 portfolios and fully reasonable $5,000 tax preparation fees. Some of those same investors owe tax bills larger than their portfolios due to wash sale rules they never understood. That's the friction of the process.
The bigger a portfolio becomes, the more important it is to control these friction points. Being intentional about managing for unrealized gain evolves to the forefront of wealth management priority. This is even more acute for older investors and those with charitable leanings since unrealized gains are tax-free at any owner's death and when donated. Separately, long-held unrealized gains add an element of compounding even if you do ultimately sell and pay the capital gains tax. Simply deferring tax from lack of transactional activity can add a fourth to dollar returns over time. Add in the compounding with the step-up in basis rule, and an unrealized gain is often 60% more valuable than a realized gain.
Adding to the confusion is the fact that paid taxes do not impact percentage performance in performance measurement software while significantly hindering dollar growth. For example, a $1 million gain in a $4 million portfolio might have a $238,000 pending tax bill based on whether it is sold or not. If sold at year-end and taxes paid from the account, the remaining $3.76 million invested afterward would generate the same percentage return next year regardless of starting amount. But those dollars lost to taxes would have generated dividends and growth as well if left alone and possibly tax-free as described previously.
These are several reasons to consider portfolio construction methodologies designed to improve overall performance and to help investors focus on dollar return, not mesmerizing and fleeting percentages. After all, when retirement rolls around, they can only spend dollars.This is article is published in the February/March 2022 Forum. Read the full magazine here!
About the Author
Gil Baumgarten is a 37-year veteran of the investment industry. In 2010, Gil left the brokerage world to start Segment Wealth Management, a fiduciary and fee-only firm where the interests of the client and the firm could align. He is a multi-year recipient of the Top 1,200 Financial Advisors in America distinction by Barron’s, where he also ranked in the Top 50 Advisors in Texas. In 2021, Gil launched his first book titled, FOOLISH: How Investors Get Worked Up and Worked Over by the System, which hit #1 Best Seller status on Amazon.