Like a lot of families, we’ve been doing things differently while social distancing during the pandemic. In addition to dusting off board games and semi-regular family walks, our latest streaming service has allowed us to catch up on classic TV, including Seinfeld.
More than three decades since it hit the air, there’s still something about the sitcom that came to be known as the show about nothing. That worked in the world of comedy, and may give us something to think about in the more serious world of portfolios.
I’m certainly not suggesting that investors set up portfolios once and ignore them thereafter. On the contrary, it’s imperative to be aware of economic developments — such as the market movements since the onset of Covid-19 — as well as any changes to the businesses behind individual securities.
Financial advisors are the source for this kind of information, reviewing with clients what’s relevant (including the effect on the investor’s appetite for risk) and deciding if adjustments are warranted. Those may include portfolio changes, behavioural changes, or both — or nothing at all.
The critical point is to resist the urge to make changes for the sake of change alone. The urge to just do something can be particularly harmful to a non-registered portfolio.
Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.
If those portfolio changes are based on a focused review, then the tax implications should not stand in the way of action. However, if the original portfolio continues to suit the investor’s planning needs, then a premature change not only drifts away from the plan but also compounds that diversion by triggering taxes unnecessarily.
A tale of two investors: Gerry & Jorgé
Consider sister and brother investors Gerry and Jorgé, 40 year-old fraternal twins saving for an elaborate trip together for their 50th birthdays. Both have high incomes, so we’ll use a 50% marginal tax rate. Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18, but has since come back to $14. It pays no dividends.
Despite the recent price decline, Gerry leaves her investment alone. Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells.
With a fair market value of $14,000 and a $10,000 adjusted cost base, Jorgé realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.
A few months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.
Ten years later when it’s time to book the trip, VanDelayed is at $28.
Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.
With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.
Even though Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, putting him $750 behind Gerry. The amount lost would vary depending on the growth rates, but, as long as there was indeed growth, the difference would never come out to nothing — which is something to think about.
Doug Carroll is tax and estate counsel to Aviso Wealth in Toronto