In this series, we provide our readers with two distinct perspectives on the same topic — one from an academic, the other from a practicing financial advisor.
If you have a question or two, please send them to us.
QUESTION: What is the impact of tax reform on investment portfolios?
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THE ADVISOR — JOE ELSASSER, CFP, PRESIDENT, COVISUM:
Investment portfolios don’t have a life of their own. They exist to provide benefit to someone. In my world, this is a person who has saved for retirement and will need to deploy funds over a period of time in order to enjoy a similar (or better) standard of living than while they were working. So, rather than thinking only of the “investment” implications of change, we should be thinking on two levels — first, how does the change impact the assets that comprise the portfolio and second, how does the change impact how people should use their portfolios?
When thinking about portfolio implications, remember that markets reflect all available information. Whenever there is massive change, like the tax reform bill, new information is created. As the edges of the new law are defined through regulations, private letter rulings and court cases, the winners and losers of the new law will become more evident. Markets are, in effect, a probability machine. Long before new information or interpretation of these rules comes out, investors both large and small are betting on what the landscape will become through their investments. The winners under each possible outcome, thus, already have the odds of each outcome baked into their stock price. Academics call this the “efficient market hypothesis.”
While a slight slant based on an educated, but unconventional, view may pay off in the form of greater returns, the best strategy for most retirement investors is to maintain diversification, both for the downside protection, in case your “bet” is wrong, and for the upside, because you may get a portion of the gain from an area of the markets that you may have otherwise overlooked.
The second level deserves the majority of a retirement investor’s focus because it is mostly within their control. Questions such as which account to withdraw from at which points in retirement, whether to contribute to Roth or traditional IRAs, and when to harvest a capital gain can create significant value under the new tax laws, with fewer “gotchas” (such as the alternative minimum tax) to contend with. Moreover, the appropriate tactics differ for each investor, which means that there is no “zero-sum game” where the smaller investor is fighting against the larger, more sophisticated investor for who will outperform (and who will underperform) the market as a whole.
THE QUANT — RON PICCININI, PH.D., DIRECTOR OF PRODUCT DEVELOPMENT, COVISUM:
This is a very tricky question! Taxes directly impact portfolios in two major ways. The first is through the direct taxation of capital gains, which reduces the power of compounding. The second is through the rate of appreciation of the stocks and bonds held in the portfolio. Although every investor’s portfolio will see a different result depending of their particular situation (please talk to a qualified advisor), we can attempt the following generalizations: