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Case Study: Buy-and-Hold with Tax Loss Harvesting or Active Risk Management?

By
Richard Sun
Updated
December 11, 2023
5 minute read
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alphaAI is the roboadvisor of the future, and that’s because we can do things that legacy roboadvisors can’t. We’re the only roboadvisor that offers automated risk management – in fact, that’s our primary differentiator! But to understand why that makes us better, you must first understand the nuances of tax loss harvesting vs. risk management.

In this piece, I will take you through a case study of a real alphaAI client account. You will learn more about the mechanics of tax loss harvesting and active risk management – and the impacts each can have on your overall returns.

What is tax loss harvesting?

Tax loss harvesting (TLH) is the practice of selling investments that are down in order to realize losses. These losses are then used to offset realized investment gains, with the goal of reducing your capital gains tax burden.

TLH Limitations

Although TLH sounds great, there are many limitations that investors may not be aware of. For one, after you sell a security at a loss, you cannot buy a similar security back within 61 days (the window is 30 days before and 30 days after the sale). If you do so, you cannot count those losses against your gains.

Another major limitation is that there is a $3,000 annual cap on TLH. This means that the individual taxpayer can only write off a maximum of $3,000 in net losses every year. 

TLH is the main selling point of legacy roboadvisors, but we don’t think it’s very compelling.

When legacy roboadvisors, such as Betterment and Wealthfront, became popular back in the early 2010s, one of their primary differentiators was their automated TLH software. Certainly, the automation of the TLH process introduced many conveniences and efficiencies over previous, more manual methods. However, we question whether TLH is as compelling as proponents would have you believe.

According to researchers at MIT, TLH could yield an additional 1% in annual return (source). This result is not bad and can compound over many years; however, it’s not great. We argue that a better option is active risk management. Below, we will take you through a case study to illustrate that TLH isn’t as great as it’s made out to be.

What is risk management?

Risk management, in the context of portfolio management, is the identification, assessment, quantification, and management of risk in an investor’s portfolio. Some common methods to manage risk include diversification, asset selection and allocation, net exposure management, and hedging.

Risk Management Limitations

Since risk management often involves buying and selling securities in the short term, losses incurred typically don’t qualify for TLH. Securities sold and bought back within the 61-day window are subject to the wash sale loss disallowed rule. However, this doesn’t mean you can’t realize any benefit from short-term losses. The IRS allows you to adjust your future cost basis by the wash sale amount, reducing your overall capital gains. 

Figure 1

Let’s look at Figure 1 as an example. Say you buy a stock for $100, sell it for $80, then buy it back in the short term. You would incur $20 in losses subject to the wash sale loss disallowed rule, meaning you can’t use it for TLH. Later on, you buy the stock back at $80 and sell it for $100, incurring $20 in capital gains. You might think you would have to pay taxes on that $20. However, you can adjust your $80 cost basis by the previous $20 wash sale loss. Your adjusted cost basis would be $100 = $80 + $20. So your net adjusted capital gain would actually be $0. Many investors are unaware of this rule!

alphaAI’s Approach to Risk Management

At alphaAI, every investment strategy has four modes that correspond to varying market conditions. We switch modes in response to the market to help control your risk. If the market is weak or volatile, we might switch to a more conservative mode to help limit your losses. If the market is doing well, we might switch to a more aggressive mode to help enhance gains. Every strategy is tailored to each investor’s unique risk profile. 

Because we are doing some short-term trading, you will incur more capital gains than with a purely passive approach. But the idea is that the superior performance from risk management more than offsets any potential TLH gains you would achieve with a buy-and-hold strategy. After all, there’s a reason why there aren’t any great investors who use purely passive investment approaches. In the next section, we will go through a case study that supports our stance.

Case Study: TLH vs. Risk Management

Figure 2

In this section, we will be referring to Figure 2. This case study documents the success story of a real alphaAI client (aggressive risk profile) in the years 2022 and 2023 YTD through 11/30/23. All alphaAI return figures and calculations represent a real account and are not simulated.

Let’s go over a passive strategy first. Assume that you start 2022 with $100,000 in your portfolio and are 100% invested in the S&P 500. In 2022, the S&P 500 lost ~20%, so you would have lost $20,000 and ended the year with $80,000. In 2023 YTD, the market gained back 20%. So, you made $16,000 to end the year at $96,000. (Note that just because the market made back 20% doesn’t mean you were made whole!)

Let’s say that in 2023, you incurred $10,000 in capital gains due to trades you made. You can apply a maximum of $3,000 in TLH to reduce your net capital gains to $7,000. Assuming your short-term capital gains tax rate is 25%, you would have to pay $1,750 in taxes, leaving you with $94,250 after taxes.

Now, let’s go over a real alphaAI client account. He started 2022 with $100,000 and lost 15% to end the year with $85,000. Even though he lost money, he was able to lose less than the passive approach thanks to our risk management technology. 

In 2023 YTD, he saw a massive gain of 46%, which was, again, a result of our risk management technology. He ended 2023 with $124,100, which is a significant improvement over the $96,000 achieved with the passive approach. Since all gains were short-term, his capital gains were $39,100. However, there was a $15,000 cost basis adjustment from the wash sale losses accrued from the year prior, which reduced net capital gains to $24,100. At a tax rate of 25%, he paid $6,025 in taxes.

You might be thinking that the $6,025 he paid in taxes was significantly more than the $1,750 in taxes paid in the passive strategy. This is true; however, we need to look at the overall account values to make a fair comparison. alphaAI’s 2023 ending value after taxes and fees was $117,780. That’s $23,530, or 25%, better than the passive strategy!

So after going through this example, I leave it up to you to decide which is more appealing. On the one hand, we have passive strategies, which could yield up to $3,000 yearly in reduced capital gains through TLH. On the other hand, we have alphaAI’s approach, which has the potential to significantly outperform buy-and-hold through automated risk management – in this case, we performed more than 20% better than buy-and-hold! I know which side of the fence I stand on.

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