A successful self trader – Rule # 45
It is a common belief that your investments should be tax-efficient. Remember, taxes should never ever drive your investment strategy. Investing should always be a risk-return trade-off. If you get tax benefits in the form of exemptions or lower tax rates, it is just the icing on the cake. The danger here is that a tax-based strategy can lead to wrong allocation and bad investment decisions.
Taxes should be incidental, not primary to your decision
“Let me hold on to the stock for another 3 months as these profits will become a long term gain”. This request from one of the investors set me thinking. Why are investors overly obsessed with saving taxes in the investment process? A zero tax versus a 15% tax surely makes economic sense. But is it worthwhile taking a 3 month risk to save tax? My response would be a strict and an unequivocal “NO”
Firstly, I believe that a tax-based approach tends to misallocate capital. Back in the late 1990s, buying bonds for tax saving made sense as interest rates were at an elevated level. If you bought a 15% IDBI bond, your yield after considering the tax break under Section 88 would have been above 18%. That is not true any longer. Surely, taxes cannot drive your investment decision.
Secondly, they can lead to bad investment decisions. Let me go back to the case in the first paragraph. 3 months is a long time in the equity markets. Prices could actually crash, alternative investment opportunities may just vanish from the markets or the economic conditions may simply deteriorate. The risk is that a tax obsession may have led to a bad investment decision.
3 questions to be asked to give weightage to taxes
Is the tax break primary or secondary?
Always ensure that tax breaks are your secondary consideration and not your primary perspective. If the investment decision makes risk-reward sense, then the tax benefit can be an added benefit. Nothing else!
What Is The Time Frame For a Tax Benefit To Fructify?
If you have to wait for over 15 days to avail a tax break, the risk may outweigh the returns. Risk manifests itself in two ways viz. the returns lost and the alternate opportunities lost in the process. Tough one that!
Have you read between the lines for the catch?
Most tax benefits come with an in-built catch. It may be in the form of a longer lock-in period or it may be in the form of a hidden call option clause in case of bonds. These clauses can make a world of a difference.
“In each and every investment decision we ask ourselves what is the Return on Investment (ROI)” – Chairman of FedEx
5 situations when Tax-based investing can be crazy
- It can be crazy when the markets are in an uncertain mode. We saw it at the peak of the tech crisis in 2000 and at the peak of the sub-prime crisis in 2008. Market value to the tune of trillions of dollars was wiped out in a matter of days. In an emergency, don’t worry about the tax rates on short term and long term capital gains. Find the nearest exit and think with your feet!
- You must be careful when fundamentals of the industry or the company are deteriorating. The signals are always obvious. Imagine waiting for a long term capital gain in a company like Kingfisher or Suzlon. In retrospect, it would have been absolutely insane to be driven by taxes in such cases. When the ship is sinking, be a rat. Then tax breaks don’t matter!
- Being a sucker for the tax relief story. You always judge tax break by your peak tax rates. What matters is the effective tax rate that you are paying. Then think about what is the tax advantage you are fighting about. In most cases your limits are already used up for other exemptions. Not a great idea!
- There is another perspective to this tax story. Investors tend to evaluate investments by how little taxes companies pay. That is ridiculous. Remember, taxes and dividends are two sure shot indicators that the company has cash. There is no reason to prefer a company just because they are postponing their tax liability through investment allowances. Trash this argument!
- Look at taxes in the larger scheme of things. If you make 20% returns on your investment in 10 months what do taxes boil down to? At current rates of short term capital gains tax, it works out to 3% on your overall investment. Should you forsake a certain profit today for an uncertain profit in the future? Surely looks a bit optimistic for a 3% difference in ROI!
Classic examples of Tax-based investing gone awry
Back in late 2007, many HNIs were heavily invested in real estate companies like DLF, Unitech, Ansal and were also sitting on tidy gains. Profits started compressing rapidly in 2008 and by late 2008 these stocks had lost close to 95% of their value. The fall was so rapid that most were left holding onto these stocks in the hope of a bounce, which never came. Sadly, the indications were always there in the US from 2007 onwards, but the obsession of a tax-free return on long term gains prompted most of them to hold on.
The second was the case of the Deep discount Millionaire bond by IFCI in the late 1990s. A 25 year lock-in with an assurance of 16% annualized return was incredible. That too with no reinvestment risk! The millionaire dreams went sour post-2000 when interest rates started falling. IFCI exercised the in-built call option and decided to borrow again at lower rates. The investors were suddenly exposed to a huge reinvestment risk and their dreams vanished. Sad indeed!
Takeaways from the “TAX-BASED INVESTING” debate
What is the crux of the matter? Investing always has been and always will be a trade-off between risk and return. Never, ever allow tax exemptions, tax breaks and tax liability to determine your investment decisions. In the process you expose yourself to the uncertainties of the market as well as a prohibitive opportunity cost.
As Jim Cramer put it, “It makes a lot of sense to make peace with the Taxman”. At the end of the day, it makes more sense to make a gain and pay tax on it rather than try to save tax on a capital gain and end up with no gains in the final analysis. Stop fearing the tax man and start fearing missed gains and missed chances. Believe me, you will never regret it!
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