2011’s Top Ten (Part 8)

We’re looking at my top ten financial planning resolutions. Number 8 is to be sure to think about taxes, but not to think too much about taxes.

One of the mistakes beginning investors make is to forget about taxes. They buy and sell indiscriminately, forgetting the effect that short term gains have on their tax bill. Or they fail to take losses when an investment goes down—losses that can help shelter gains when other investments go up. When their taxes are due, they don’t see how their portfolio actions are linked to the taxes they have to pay. It’s easy to overestimate how well a portfolio has done, because the only way to figure out the cost of your activity is to do it yourself.

But it’s easy to overestimate the impact of taxes as well. So you have people overpaying for municipal bonds in their own state, because they want to avoid state income taxes at all cost. You have investors that never diversify an appreciated stock portfolio because they don’t want to pay capital gains taxes. You find people who don’t refinance their mortgage at a lower rate because they like the mortgage interest tax deduction.

There are all errors. It’s sensible to wait a year before taking a gain, but only if there is a gain to be taken. But if you avoid capital gains completely, eventually you end up with a portfolio concentrated in just a few names. Portfolios like this are risky, because one inappropriate remark or unforeseen error can wipe out an immense amount of savings. Owners of BP stock or Enron or AOL can attest that it’s better to take gains when you have them.

Taxes are important. But obsessing about them to the point where you ignore common-sense just doesn’t make sense.

Douglas R. Tengdin, CFA
Chief Investment Officer
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