Analysis shows that when it comes to the stock market, it’s best to walk to the exits early rather than rush out late
As the end of the year approaches, investors and advisors are likely scrutinizing their non-registered investment accounts for losing investments, with a view toward tax-loss harvesting in December. But however prudent the practice is, there are crucial ramifications for portfolio returns.
“As investors sell off their losers, it puts considerable downward pressure on those stocks at year-end,” wrote Derek Horstmeyer, assistant professor of finance at George Mason University’s Business School, in a recent piece for the Wall Street Journal. “It also tends to give ‘winner’ stocks a slight bump because once investors sell the losers, they usually want to put the proceeds back into equity and not cash.”
To determine the magnitude of the effect, Horstmeyer analysed the past 25 years of returns data for all stocks trading on the New York Stock Exchange and Nasdaq. He then divided the stocks into two categories: winners, those that experienced a positive return over the first 11 months of a given year; and losers, which suffered a negative return over the first 11 months.
Horstmeyer found that the average difference in return between winner stocks and loser stocks in December can average 1.11%, which amounts to more than 13 percentage points on an annualized basis.
“Stocks categorized as winners had a median return of 1.46% in the month of December over the past 25 years, while stocks categorized as losers had a median return of 0.35% in the month of December,” he said.
That’s compared to months other than December, where winners typically outperform losers by only 0.18% on average.
“Interestingly, this effect is almost entirely concentrated in years when U.S. markets performed well, which they currently seem on track to do,” he said. In years that saw the S&P 500 advancing by more than 30%, winner stocks delivered a median return of 1.71% in December, while loser stocks took in a median return of -1.10%. That amounts to a 2.81% different in returns in the last month of the year.
Intuitively, that boom-time December disparity makes sense; with a smaller pool of losing stocks to select for tax-loss harvesting, the downward pressure on stock prices tends to be more concentrated and severe.
In contrast, Horstmeyer found that bust years — which see a decline of at least 10% in the S&P 500 — typically see a considerable number of loser stocks to sell at year-end. Because of that, the gap in returns between winners and losers is considerably narrower at just 0.1%.
“With markets up more than 20% year-to-date, it might be a good idea to pay attention to the effects that tax-loss harvesting could have on your year-end portfolio,” he said, suggesting that investors consider rotating out of losing stocks ahead of the procrastinators who’ll act midway through December.
Such early moves might be afoot in ETF land. A National Bank Financial report on ETF flows in October shows that while Canadian equity and fixed-income ETFs saw an aggregate influx of capital, there were net outflows in specific sub-categories. That includes ETFs with exposure to preferred shares, which have materially underperformed other segments of the equity market.
Horstmeyer also suggested that adventurous investors could buy the winners at the start of December and short the losers, describing it as “an opportunity to make money … without taking on additional market risk.”
