A newbie undergoing his inaugural financial literacy conversion experience is disheartened a few years out of residency. His taxable account reads like a sloppy record of investing mistakes, littered with individual stocks and actively managed, high expense ratio funds.
Like many of us, he made his share of mistakes trying to beat the market before realizing that high active management fees, a lack of diversification from owning individual shares and high churn costs from rapid stock turnover were undermining his investment strategy.
He now wants to match return returns rather than beating them, and is prepared to stick with low cost, passive index fund investing.
What should he do with his "orphans," those random funds that do not align with his Investor Policy Statement?
Following are a few guiding principles to consider.
First, do no harm
If selling the orphan funds would trigger a large capital gain, consider holding onto them. It's often a bad idea to sell 1) when they've increased in value above the basis (the amount you paid at time of purchase) and 2) you have a high tax bracket due to being in your peak earning years. In this case, leave the orphans alone.
Our newbie is fresh out of residency, so he has a long investing career ahead of him. The scale of his future contributions is likely to overshadow his current investments, such that he will dilute out the impact of holding his orphans by investing everything else in index funds so they represent a smaller proportion of his portfolio over time.
Give It Away
You know who loves orphans? Charities! If you happen to hold orphan funds where selling them would cause you to incur significant capital gains (and be taxed on those gains), and you either don't need the money or have charitable giving as part of your annual budget, contributing orphans to a qualifying nonprofit organization is a win-win scenario.
Your brokerage liquidates the orphan stock(s) and sends the organization the proceeds, and the organization pays no taxes.
You simplify your portfolio, take a tax deduction and ideally help to fix broken world.
The federal government feel positive for promoting philanthropy as a civic duty among the taxpayers.
Be careful to look for the exact phrase 501(c)(3) in the organization's literature to ensure it qualifies as a nonprofit in the eyes of Uncle Sam.
If you have a donor advised fund, you can donate your orphans to your DAF and benefit from a tax deduction as well.
You may wish to consider grouping your contributions (either gifting several years of contributions in advance to your DAF) so that your larger one-time contribution makes it likelier you will exceed the standard deduction using itemized contributions under recent tax law.
Don't Let The Tax Tail Wag The Dog
Finally, you can always suck it up, take the tax hit, and sell in order to buy funds consistent with your Investor Policy Statement.
For most newbies fresh out of residency, such scenarios should not cause disproportionate angst, because if you incur capital gains it means you've made money instead of losing it. Remember that making money is your objective and should be cause for greater celebration than anxiety.
Paying capital gains on the sale of funds or individual stocks you never would have purchased knowing what you know now? That's a form of continuing financial education I like to call "The Moron Tax."
We've all paid it, and we'll all pay it again, so take some consolation from being in excellent company.
Lemony Snicket book plots notwithstanding, how do you handle your orphans?
Comments 2
Firstly there is no problem owning individual shares. Owning them may be Heretical to the bogglehead code of excellence but they may provide a specific diversification function when viewed in the context of an entire portfolio. I own individual shares in some stocks. I can precisely point to how owning these issues gives me what I want in terms of alpha and beta in the portfolio. Sometimes owning shares in ETF’s that provide a specific tilt is desirable. Tilt’s emphasize a given market feature like value or momentum and are useful to own in some parts of the business cycle and not useful to own in other parts, so I buy them when useful and sell them (turn them into cash) when not. Owning tilts may be a bit more expensive than owning the market, but the reason you own them is on the average they pay more than they cost. It’s the same reason I employ a AUM manager. His presence and expertise in my portfolio pays me more than he costs. I don’t let some friggin plumber with his crack showing, with 1M in the bank and a blog tell me “the right way”. Had he actually done it the “right way”, he’d have 2M in the bank. If you are DIY, I have read studies that show the average DIY leaves 4% compounded interest on the table due to mismanagement and investment poor timing. If you don’t think you are timing the market in some way then you don’t have the first clue about what you are doing. Buying higher highs each month is timing the market. If you think it’s not you are just pretending.
If you’re worried about tax consequence the “orphan” must be in a brokerage account. If the “orphan” is in a pretax or Roth just sell it and reallocate those proceeds according to your risk management plan. If in a brokerage you can use market timing to avoid taxes. Let’s say you own fund ABC that has a 1.5% cost of ownership and a 50% capital gain and a 7% return and inflation is 2%. That means your return on ABC is 7 – 2 – 1.5 = 3.5%, pretty much what you can get in a total bond fund. Let’s say the risk (SD) of owning ABC is 18%. You therefore own an asset that pays 3.5% and is VERY risky. Look in the mirror and ask yourself if you’re a Moron. You can own a bond fund with 5% risk, a 70% reduction in risk for the same return you get owning ABC. BUT BUT the taxes! If you own 100K of ABC 50% or 50K is CG. If you sell it and you pay 15% taxes you will owe $7500 in taxes on a $50K gain, that is you will have $92,750 to invest in a product that has 70% less risk.
What does less risk mean? When the market (with 15% risk) dumps in half ABC with it’s higher 18% risk will dump 60%, So by owning this turkey your $100K is now worth $40K, 10K less than you paid for ABC in the first place and you were worried about spending $7500 when you could have walked away with 92.5K? Look in the mirror again and who do you see? If you own some other stocks (say SPY) at a higher basis (you’ve been buying those higher highs) you can tax loss harvest some early in a downturn. When your SPY shows a loss of say 7500 on specific tax lots you can sell those lots at a loss and reinvest the money from the sale in a similar but not the same asset class, you could sell SPY at a 7500 loss and buy VTI with the proceeds. You can then sell ABC and apply the $7500 loss against the capital gain ABC will generate for a zero dollar tax bill on the sale of ABC. If you overshot the TLH a little all is still good. You can bank that excess TLH to use at a later date against another capital gain. In fact if the market dumps 50% and you own a big wad of SPY which goes into a loss, sell the SPY, book the loss and immediately buy VTI. You now just put some extra money in the bank in the form of tax loss which you can use to offset taxes later on. A dollar you don’t spend in taxes is a dollar that stays in your pocket and a dollar that you can then invest. This idea that you “can’t time the market” is nonsense. Of course you can if you understand what you are doing and have a well thought plan to execute when the correct conditions arise. Markets are dynamic so learn to be dynamic. There isn’t a future in being a Moron. Don’t believe everything the plumber tells you, his crack is showing.
I was fortunate that all my unwanted funds were in my retirement accounts so there was no tax hit for cutting bait and doing the switch.
If they were in a brokerage account I would either bite the bullet and sell and incur capital gains taxes (hopefully offset by prior tax loss harvesting) or just keep it if the tax hit was going to be too high.