Clients generally understand how our low-turnover methodology equates to better returns over time. For example, with enough tax deferral, an 8% return can be augmented to a 10% return (in dollars). But that’s not all. Preserved gains that remain untaxed until death are tax-free in many circumstances. This can make low-turnover methodologies even more compelling. Despite the power of these factors, protecting gains and principal is still the first order of business at Segment.
There are two primary reasons for this protective stance. First, large losses require much greater gains in the future to recover. For example, a 50% loss takes a 100% gain to get back to even. Second, market losses apply to the entire value of the position, while taxes only apply to the gain portion. Another factor to consider is that in cases where a step-up in basis is not a consideration (like in a trust), taxes are essentially unavoidable at some point, so tax payment itself is not what is at stake. Rather, the difference between the tax payment now and the tax payment you would pay in the future is the deciding factor. When the time value of a tax payment becomes the only consideration, the hurdle in a decision to sell is lowered significantly.
For example, let’s say you paid $100 for a share of ABC Corporation. Two years later, the stock is worth $180, and the market (or the stock) is at risk of a decline, but you want to avoid the tax on the gain created by a sale. If you sold the stock, the maximum tax rate is 23.8%, and this would apply only to the $80 gain, resulting in a tax of $19.04. On the other hand, if the stock were to decline only 11%, that loss would be greater than the tax ($19.80 decline vs. $19.04 in tax). And if the stock price were to decline by $20 and was then sold, you would also lose the tax on the remaining $60 profit (Loss of $20 + tax of $14.28 = $34.28 total). So the highest possible tax correlates to the greatest amount of protection when stocks decline.
This decision-making requires the financial version of Maslow’s hierarchy of needs to create a properly weighted decision tree that considers all the variables. This weighing is part art and part science and, in my case, is seasoned with 38 years of experience. And even still, we never make the perfect call. We are only trimming around the edge, seeking forms of enhancement. This trimming can make market declines doubly unsettling since we do tend to trade more frequently as we seek shelter, and clients know that activity was prompted by declines and often creates taxes too. We believe that paying some taxes is better than bearing the full onslaught of a market decline. Suffice it to say that never generating taxable gains is a worthy goal but would surely also not be optimal.
Segment’s investment committee spends hours monthly debating the merits of various courses of action or inaction. In the absence of compelling evidence to the contrary, we always lean towards inaction. Some clients don’t like selling anything at a loss; some don’t like taking taxable gains either. But these same clients will also say they abhor market losses too. No matter how you slice it, you cannot have your cake, eat it too, and then have seconds. In our desirability hierarchy, we rank creating and protecting gains from market losses as #1. This inclination naturally corresponds to unrealized gain (untaxed) in an upward-trending market. But when markets turn nasty, we have more difficult choices to make. In such a market, we will generate sales, and taxable gains are quite often the lesser of all the evils.
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