Posted on October 10, 2011 by David Laidlaw
Managing any portfolio, especially taxable accounts with low cost basis positions, requires a delicate balancing of the following factors: risk, reward, current income and realized capital gains.
The most direct relationship of these factors is between risk and reward. In general, risky assets provide higher levels of return, but with higher potential for losses. Risky assets include common stocks, derivatives (such as options), leveraged investments and commodities. Safer assets include cash and high credit quality bonds with short maturities. The choice between these assets is especially stark now. Investment grade bonds have provided steady returns over the past years of stock market volatility, but bonds currently offer almost no potential for future gains. For instance, the current 10-year US Treasury Note provides a yield to maturity of only 1.8%. On the other hand, common stocks have the potential to provide total returns of more than 10% per year for an extended period. However, stock returns have disappointed and experienced two periods over the last decade where these investments lost almost half of their value (from 2000-2002; and 2008-2009). Given these choices, our preference is to invest in risky assets up to the level at which investors can accept the volatility in their full portfolios without causing too much stress.
The level of income a portfolio is able to generate is also connected intimately to the risk of that portfolio. Given today’s extremely low interest rate environment, a safe portfolio or security is one that provides very little income. There is no safe investment that yields 5% and will be able to preserve principal. Even though the US debt has been downgraded, US treasuries are still the closest thing in the world to risk-free assets. Right now, all Treasury Notes which mature in less than 5 years yield 0.8% per year or less. Even 30-year bonds yield only 2.76%.
Any level of yield above that provided by treasuries with the same maturity entails risk; the greater this spread, the greater the risk. For instance, 10-year bonds issued by the Italian government yield 5.5% even though the risk of default on those securities within the next 5 years appears to be substantial. It is possible to obtain yields over 5% through investment in long dated (10 year+) corporate bonds. However, these bonds are not investment grade –typically BB – and a 1% increase in interest rate would produce a 12% loss in principal. Finally, it is possible to obtain 9-10% yields in high yield/junk bonds where the risk of loss is high. In summary, we do not feel that it is worth the risk to principal to invest in more speculative bonds to obtain higher yields.
Many investors have more stocks than optimal due to the presence of large stock positions which were purchased years ago for much less than current market values. Selling these positions will incur capital gains taxes of 15% to the Federal Government plus various state taxes with a maximum of about 10% if sold by a resident of a high tax state such as California. An aversion to pay capital gains taxes often skews the allocation of a balanced portfolio toward a higher percentage of stocks versus less risky fixed-income investments. We strongly believe that tax considerations should not dictate investment decision making. The appropriate allocation between risky and less risky assets is individualized for each investor. However, this decision is the most important concerning how a portfolio will perform through market cycles. If an allocation is skewed too heavily toward risky assets, it would make more sense to sell low cost basis stocks and pay the associated taxes than continue with a portfolio that is too volatile.
Tax efficient investing and earning a sufficient current income through dividends and interest payments are important goals. However, there are trade-offs between meeting these ends and constructing a portfolio that has an optimal blend of risky and safer assets.