Investors and traders in the stock market, like every other type of person, are people of habits. We fall into routines, expectations, approaches. We see patterns throughout the stock market.

One of the things we do is try to deduce seasonality in these patterns. “Sell in May and go away”, “Santa Claus Rally”, and so on.

Mostly, these strike me as silly. If everyone knows about a pattern or a strategy, they adjust to it until the pattern goes away. But there is one pattern or strategy worth being aware of: year-end tax loss selling or tax loss harvesting. (For our purposes, I will use the latter term from here on out).

Let’s break down what this is, why it’s different, whether it’s a useful strategy, and how we can benefit from the strategy, even if we’re not using it.

I discuss much of this in this video as well:

What is Tax Loss Harvesting?

We pay taxes on our net realized capital gains after each year. Capital gains are the profit we make when we buy an asset for one price and sell it for a higher price. (Capital losses, of course, are the reverse).

We of course hope to buy stocks that eventually go up in price. But beyond that, there are three key things we control about the tax process.

Long-term vs. Short-term

In the U.S., capital gains get classified in two ways. If you hold the stock for less than one year before selling it, the gain is treated as ordinary income, the same as your wages or any other money you make. If you hold the stock for more than one year, the gains are classified as long-term capital gains.

This matters because long-term capital gains are taxed, usually, at a lower rate than ordinary income. I think there are a lot of more important reasons to focus on a long-term investing strategy (I look at owning stocks for 2-3 years as a starting point, when I analyze them). It is a nice side benefit, though, that it is more tax efficient than buying and selling a lot of stocks month after month.

Net and Realized

We are taxed on our “net realized capital gains”. Net meaning that our capital losses will reduce our capital gains. If we sell one stock for a gain of $2000, and another stock for a loss of $1000, we will pay taxes on a net of $1000 in capital gains (assuming they are both long-term capital gains).

Tax loss harvesting is, basically, the idea of selling your losers to offset your winners. Because the third thing we control is “realized” capital gains – we only pay on stocks we’ve already sold.

Why Tax Loss Harvesting Might not be a Good Idea

Nobody likes to pay taxes. So it makes sense that we should use this strategy, right?

Even though I do tax loss harvest now and again, I’d recommend thinking about this and other tax-optimizing strategies with caution.

Our goal when investing is to buy stocks for a price less than we think they’re worth. We hold those stocks because we think they should offer us more value in the future. We will, of course, make mistakes, but our goal is to grow our money. And even after you buy a stock, you should be evaluating whether it is worth holding further based on what you estimate its value will be, vs. its current price.

If we start thinking about locking in losses or postponing a sale to avoid a short-term capital gain, we get in the way of that analysis. Capital gains is, in most cases, a 15% tax, while the money we miss out on or lose from a bad decision is lost at 100%. The tail, in other words, wags the dog.

Let me give you three recent examples from my investing for family or friends. I’m going to call out three tax loss harvesting sales I made between December 30th, 2022 and January 27, 2023.

In the first two cases, I locked in a tax loss on the last day of last year and early in January this year. Both companies, Arlo and Kimball, were key positions for me that I believed in. I was less confident about Wolverine. And in the end, Kimball and Arlo would have made me way more money if I just paid the tax last year and held onto the shares. While I would have been smarter to sell Wolverine Worldwide.

(An important point – for the loss to register, you have to wait 30 days before buying the stock again. In Arlo’s case, it was up nearly 10% after a month. Kimball was up 12%. I could have rectified my mistake and benefited from the tax saved. But that’s a tough mental game to play, in my view).

We can’t predict the future. But, we can prioritize better. Instead of thinking ‘I can lock in a tax loss’, I should have been re-evaluating each company. If I did, maybe I would have bought more shares of the first two, and sold all of the last one. Who knows? The point is, I would be focused on my analysis and not distracted. Which, I think, is a better path to success.

Tax loss harvesting is a common strategy, but I would argue it’s a little backward. Instead of looking to harvest tax losses, we can take a losing position as an excuse to revisit our analysis. The decision we make should then be based on what we think about the stock and the company.

Why am I talking about tax loss harvesting now?

I bring all this up for two reasons. First, the end of the year is a good time to watch out for tax loss harvesting. We have a better idea of what our tax bill is going to be, so it’s easier to make tax loss decisions. This doesn’t work like a clock; people will lock in tax losses throughout the year. As seen above, I tried zigging by selling some losers in January.

The bigger reason is because, even if you don’t sell any stocks to lock in losses, you can benefit from tax loss harvesting strategies. As someone deviates from just analyzing a stock and instead views it as a tax asset, we might get interesting stocks on sale.

Often our biggest advantages are looking at a stock one way that the market is looking at differently. The market – i.e. the millions of investors out there investing in stocks, in aggregate – will often focus on what’s happened in the last 3 months, and what will happen in the next 3 months.

Tax loss harvesting can exaggerate this. A stock that has been down all year probably doesn’t have a clear outlook for the coming quarter. And if it’s down, may as well sell it, right? And if you’re selling to harvest a tax loss, a lower price is almost a good thing! Which can lead to extreme cases. If we’re on the other side of that extreme case, it could work out.

How to find these stocks

How to find tax loss harvesting stocks? The basic approach is to use a stock screener. You can screen for companies that are trading near 52-week lows, and maybe throw some quality elements in so you weed out the dregs. I recently used a screener that combined a stock with poor price momentum with a stock with good earnings revisions, meaning the fundamentals looked good to analysts even if the stock itself was plumbing new depths.

A random approach to stock picking is also useful here. Scroll through different sectors or different parts of the market, for example. You will likely come across a stock or two that is down big.

It’s important to remember, losers are losers for a reason. Sometimes that reason is wrong or short-term oriented, but the market isn’t usually plain stupid. Analyzing these sorts of stocks is useful, then, because you can also get practice in understanding what the market cares about for a given company, and try to identify why things might or might not change.

Examples

I’m still digging around for stocks I want to buy, but I can offer a couple examples from last year, and one from this year I am considering.

Last year’s examples

I did a post and video about Duolingo, a company I admire whose stock plumbed new depths last December. Like many tech stocks, it had a bad 2022 as a stock. Its business was fine though, and I should have figured that out more clearly. I wasn’t bold enough to buy shares in the $60s, which is too bad because the stock trades in the $210s now.

As I mention in that video, I did buy and still own shares of Spotify. This is a similar story; Spotify’s business was more or less fine last year, but tech stocks were in disfavor. In Spotify’s case, their ballyhooed podcast bet from 2020 was losing steam. But I figured its subscribers would still grow this year, and its share price was finally reasonable. I didn’t make a huge investment, but I bought shares last November and December between $75 and $95. Those shares touched $200 today.

This year’s example

I don’t think J.M. Smucker is worth buying yet, but it is interesting. Smucker is a consumer goods maker, it makes Jif Peanut Butter, Smucker Jelly, Uncrustables, Folgers coffee and Dunkin’s home coffee, Milk-bone and meowmix pet foods, and most recently, it bought Hostess, home of Twinkies, Cupcakes, and Voortman.

The Hostess acquisition was expensive, and it’s almost surely the reason that SJM went from a $140 stock to a $110 stock, a 20%+ drop.

As a Jif Fan and someone who rarely invests in these sorts of companies, I was always curious about the company. I was happy to dive in when I saw it on a screen.

There are real reasons for concern. SJM overpaid for Hostess, but also, Hostess is a junk food company. Many investors are worried about the affect of Ozempic and other weight loss drugs, which also curb patients’ demand for addictive urges like junk food. That would hit Ding Dongs and Twinkies and other Hostess products hard.

There are also positive things to focus on. J.M. Smucker will save some money in absorbing Hostess’s business. Hostess’s business has grown faster in the past decade than J.M. Smucker’s. I can get to a price to earnings ratio of about 13x next full year’s earnings (SJM’s 2025, ending in April 2025), which is cheap.

The point of this example isn’t so much that I am going to by J.M. Smucker. It’s that, with the company reporting earnings tomorrow, if something goes bad, the tax-loss selling could get heavy. If it does, that might overdo itself, and maybe the shares will be on sale. At that point, a large dividend and ownership in the company that makes Jif might get tasty.

Know about Tax Loss Harvesting, even if you don’t use it

As we enter December, we naturally think about the end of the year. We want to close the book on 2023. In the market, we want to jot up our wins and losses, discuss our outlooks for next year, and, yes, plan out our tax payments.

I still think it’s a risk to focus on the near-term trees instead of thinking about the forest of long-term capital appreciation. That doesn’t mean it’s not worth thinking about tax loss harvesting. To the contrary, paying attention to stocks that get sold off irrationally is a way to find bargains. That’s always the case, but at the end of the year, we have a specific reason for it.

Interested in more from Middle Coast Investing? Or in talking to us? Get in touch.

Disclosure: I and Middle Coast Investing clients own positions in Arlo and Spotify. Nothing in this post is investment advice.