Turnover

Turnover carries costs. I’m not talking about those flaky fruit-filled pastries that Pillsbury sells. I’m talking about the selling and buying of stocks in your investment account.

First, there are the obvious transaction costs. When you sell one stock and buy another, you incur a commission cost. Commission costs have gone down in recent years, but they’re still not zero. Then there’s the spread between the stock’s bid and ask prices, the difference between what buyers are offering to pay and what sellers are willing to sell for. That’s another cost.

There’s also a tax cost if your securities are in a taxable investment account: the capital gains tax you incur if the stock has appreciated. (This tax discussion does not apply to sales inside tax-favored retirement accounts like traditional IRA’s and Roth IRA’s. Which is why those types of accounts can make you a better investor, as described in April 20’s post.) For as long as you hold a stock, its appreciation is tax-free to you. You get to determine when to pay the tax on that appreciation by choosing when to sell the stock. You can defer tax by deferring the sale. In fact, under current law, if you delay long enough and die holding an appreciated stock, your heirs get a new tax basis equal to the stock’s value at the date of your death, so nobody ever pays tax on the appreciation. What a deal! Makes you feel kind of foolish, doesn’t it, for having sold that Google stock the week before you got hit by a bus. (The rule about disappearing gains at death is scheduled to change next year, but there’s reason to believe Congress might act to keep the old rule. Watch this space for developments.)

Under the circumstances, why have any turnover? Well, there are plenty of good reasons for turnover. First, you may own a stock that did well for a while, but which you think is no longer a good investment. Second, you may need to sell an appreciated stock to generate cash to meet your spending needs. You can’t eat appreciation. Third, you may need to sell an appreciated stock to rebalance your portfolio back to your desired asset allocation mix.

But just because you have to have some turnover does not mean it has to be excessive. You can be astute about how you manage your stock sales. You can wait until short-term gain has ripened into long-term gain (generally, after one year and a day), since long-term gains enjoy significantly lower tax rates. You can offset gains by also selling some depreciated stocks. You can arrange your stock sales to serve triple duty: investment changes, cash generation, and asset class rebalancing, all at the same time.

One easy way to reduce excessive turnover is to invest in index funds rather than actively managed funds. By their nature, index funds tend to have low turnover, since not too many stocks enter or leave the index. Conversely, actively managed funds tend to have higher turnover, as fund managers make frequent sell and buy decisions. An in-between approach is to select a tax-efficient stock fund, where the fund managers take tax costs into account as they make their sell and buy decisions.

Okay. So there’s a tax cost to turnover. Just how significant is that cost? More on that tomorrow.