If you are able to keep calm and hold onto your investment positions during massive market sell-offs you may need to thank your inner tax nerd.
How do you feel when the global stock markets swoon? Do you resist the urge to bail out when you see the markets dropping like the Roadrunner’s anvil? If you hold tight and keep your positions, you may owe a bit of gratitude to that recessed part of your brain I like to call your inner tax nerd. Its job, you see, is to help you avoid pain, and when I say pain, I mean tax cost.
Imagine your inner tax nerd, a little creature with horn-rimmed glasses and a green eye-shade, looking over your ledgers with a wary eye. Your tax nerd’s primary goal is to keep you from paying one scintilla extra in taxes. You may not hear from your nerd much of the year, perhaps only rattling your chain in April when you file your returns and curse the government. But when markets start falling and your nerd senses uneasiness it comes to the rescue.
You see, the inner tax nerd is also plugged into your central nervous system and knows where your pain center lies. Like one of Daenerys’ dragons your nerd guards the pain center from receiving harmful impulses, for example, the urge you feel to sell your investments, stuff the cash in a plastic bag and bury your head in a foot of sand until the Federal Reserve says it’s ok to come out again. The nerd knows that while these impulses might bring about temporary pleasure they will most certainly cause permanent tax cost pain.
And what is this tax cost pain? Capital gains taxes. If you’ve been a good investor over the years, following a “buy and hold” approach, then you will undoubtedly have amassed some unrealized capital gains in your taxable accounts. If you panic during market declines and sell your taxable investments you will realize all those unrealized capital gains, report them on Schedule D and then owe taxes on the gains. That, my friends, is akin to a sharp stick in the eye (so says your inner tax nerd.)
One thing to remember about tax cost pain – it is real and quantifiable. It cuts deep and leaves a scar. Conversely, the temporary joy you feel from getting out of the market in bad times is fleeting, ephemeral, a snowflake on your tongue. Capital gains taxes, once paid, are forever gone from your investment portfolio. Forever is forever.
But wait, you say, I can liquidate my IRA or my 401(k) account when the markets fall and avoid ALL tax consequences. I’m sorry, but that’s also a losing argument. Your inner tax nerd doesn’t care solely about taxes, it also focuses on correcting your bad behavior. If you make poor decisions regarding your tax-qualified accounts, you’ll be tempted to do the same to your taxable accounts. And bad behavior your inner tax nerd will not abide.
Your inner tax nerd also knows that if you sell out of your investments in bad times you will struggle to decide when to get back fully invested. Will you trust yourself to call a market bottom? You could also be distracted by events in your daily life or, more likely, suffer so from analysis paralysis to make any decision at all. Your inner tax nerd knows these emotions create a different type of pain and works hard to keep you fully invested and on course especially when the markets are in decline.
Next time we have a big sell-off – and believe me – there will be another big sell-off, remain calm and temper your emotions. Trust your inner tax nerd to guide you safely through the storm, to protect you from tax cost pain, and to thwart your most rotten investor behaviors. And if you need further reassurance then contact your American Trust Fiduciary Investment Advisor.