The importance of a tax-efficient portfolio

Q – I manage my own investment portfolio, and I’m an active trader with an online account. However, I just paid my tax bill for 2012, and it was a doozy! A large part of it was due to tax on investments, particularly on income on distributions and sales of some mutual funds, and capital gains on various stock transactions that I thought had worked out well. I was surprised at the size of the chunk the taxman took out of my total returns. Am I doing something wrong? – Stephen L., East York, Ontario

A – You’re not necessarily doing anything wrong. But you may have fallen into the trap that so many do-it-yourself investors do. You’re looking at your investments the wrong way around.

While the asset mix of your portfolio is important, and your individual security selection might be exciting, you may be ignoring one of the biggest factors in wealth creation: tax efficiency.

Research has shown that creating tax efficiency in your portfolio accounts on average for about 28% of overall long-term investment return. Surprisingly, the factors with the next largest influence on your portfolio returns are the time you spend on management, which has a 26% importance ranking in portfolio returns, and managing your emotions, which adds up to about 20% ranking.

Believe it or not, asset mix accounts for only 17% of what goes into total return, while security selection – the item that most investors spend most time on – has only a 2% importance ranking in determining portfolio outcomes.

These are fascinating numbers, because they tell us why so many do-it-yourself investors get into trouble: They place outsized importance on the aspect of portfolio management that contributes the least impact to long-term portfolio growth – security selection. And I suspect this is what has happened to you.

It’s easy to get carried away with online trading, but in the process, you’re not only generating costs in the form of brokerage commissions, but you may very well be inadvertently accumulating a hefty tax bill on the various buys and sells of your investments through the year. It all takes a sizeable chunk out of your investment returns and puts it in someone else’s pocket. There’s probably no other activity in the world where individuals will so eagerly perform a robbery on themselves.

The key is to step back from the trading screen for long enough to take a look at your whole portfolio. And then ask yourself:

* Is it tax efficient? Am I attracting maximum tax with every transaction or am I minimizing the tax hit? Am I maximizing my use of Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans?

* Is it low cost? Am I using investment strategies that reduce my overall trading, transaction, and management costs, such as allocating at least some portion of my asset mix to low-cost exchange-traded funds. In the case of mutual funds, have I looked at corporate class shares?

* Am I mitigating risk? Am I diversifying my portfolio with enough non-correlated asset classes to suit my tolerance for risk. Am I using hedging or income-generating strategies with options? Or am I essentially “throwing darts” every day, and hoping for the best?

Granted, these are not particularly easy questions to answer, and you might just have to break down and talk to a financial advisor. As a self-directed investor, this probably goes right against the grain. But you sound as if you’re in a bit of trouble sorting out how your various investment activities are affecting your overall returns. An objective study by an independent fee-only advisor (not one affiliated with a bank, brokerage, or other financial institution) could go a long way to helping you get your investments back on the right – tax efficient – track. – Robyn

The importance of a tax-efficient portfolio was last modified: August 24th, 2015 by robyn