'People who complain about tax," the old adage asserts, "can be divided into two groups: men and women." The view that paying taxes is to be avoided doesn't just entail a potentially uncomfortable brush with the taxman.
It can also corrupt your investment decision-making in a most expensive manner.
If you've thought, "I won't sell now as I'll have to pay capital gains tax", or "I should sell now to lock in my losses", or "this investment is attractive because of the tax deduction", then tax considerations, not the merits of an investment itself, are adversely affecting your portfolio's returns.
Never selling
Not selling an investment when you should because you don't want to pay capital gains tax is perhaps the most common trap. This behaviour is caused by "anchoring", a cognitive bias where we use irrelevant information - in this case tax - to make investment decisions.
The problem is that holding on to an investment to avoid a tax bill may well mean you end up owning an overpriced stock.
That exposes you to far more risk of significant loss because, over time, stock prices tend to reflect the underlying value of a business.
To avoid this pitfall, shift attention away from the price paid (and the tax due) to the difference between the price of a stock and the value at which it trades. Investors could even try removing any reference to the purchase price in your broking account and replace it with estimated value. That way they have a subtle reminder that price and value - rather than purchase price - should be key to investment decision making.
Selling too soon
The second trap relates to selling stocks that have fallen in value to create a tax write-off, the opposite of never selling to avoid capital gains tax - although the same thinking lies behind each.
An investor's decision to sell should be based on a judgment about price and value, not what tax might be saved.
A useful tip to avoid this trap is to record the reasons for the original investment, including a sell price, and whenever tempted to sell, review the reasons for making the original investment.
The average Australian's obsession with negatively geared (loss-making, at least in yield terms) residential property is evidence of this trait, encouraging people to invest in property that may yield less than a bank term deposit. The tax deductibility of interest payments encourages this type of thinking.
Investing in an asset through the lens of tax deductibility tends to warp one's thinking to the point where losses become an advantage (the bigger the losses, the greater the deduction). Again, one ends up focusing on the tax aspects of an investment rather than the price one pays for it. This was especially true of all those investors in managed investment schemes. Many ended up with savage losses.
The solution to avoiding these traps is to concentrate on the value of an investment, not the tax implications of buying or selling.
Ask yourself the following two questions: Would I still want to sell/hold if my tax rate was 0 per cent, and would I prefer to pay a tax bill and make a profit or pay no tax and make a loss?
By focusing on value and buying great businesses for less than they're worth, investors will more than make up for any short-term "benefit" received from tax trading.
Keep track of tax
Another trap to avoid is where tax trading starts to look appealing.
Investors often start "tax trading" to meet a pending tax bill.
Investors can avoid that by keeping a running record of their likely tax bill (use the calculator on the ATO website) and putting aside enough cash to cover it.
Finally, understand that paying tax is a natural consequence of making money. Successful investors don't let prospective tax bills stop them from making the best investment decision.
They understand short-term "tax trading" reduces their chance of long-term outperformance, which, ironically, is the aim of avoiding tax in the first place.
Becoming a successful investor entails buying underpriced companies and selling overpriced ones. It has nothing at all to do with the tax paid on the way through.
Apply the above techniques and investors should avoid some of the worst tax traps and enjoy better portfolio returns.
Frequently Asked Questions about this Article…
What common tax-related traps should everyday investors watch for when managing a portfolio?
Common tax-related traps include not selling to avoid capital gains tax (CGT), selling too soon to harvest tax losses (tax trading), and choosing investments primarily for tax deductions (for example, negative gearing). These behaviours let tax considerations, rather than price and value, drive decisions and can harm long-term portfolio returns.
How can capital gains tax (CGT) cause me to make bad investment decisions?
Worrying about CGT can lead to anchoring bias — holding overpriced stocks just to avoid a tax bill. That increases your exposure to losses because stock prices tend to move toward their underlying value. Focusing on value instead of the purchase price or tax due reduces this risk.
What is tax trading and why is it risky for long‑term investors?
Tax trading is buying or selling assets mainly to change your tax position—such as selling losers to create write-offs before a tax bill. It's risky because it prioritises short-term tax benefit over sound price/value judgements, lowering the chance of long‑term outperformance.
How can I avoid letting tax drive my buy or sell decisions?
Shift focus from the price you paid or the tax due to the gap between market price and estimated value. Practical steps include removing purchase‑price references in your broking account, replacing them with estimated value, and recording original investment reasons (including a target sell price) to review before acting.
Should I sell a losing stock just to lock in a tax deduction?
No — you should decide to sell based on the investment's price versus its value, not the potential tax deduction. If tempted to sell for tax reasons, review the original investment thesis and your target sell price first; don’t let tax alone determine the decision.
How can I plan for my likely tax bill without resorting to tax-driven trading?
Keep a running estimate of your expected tax bill and set cash aside to cover it. The ATO tax calculator is a useful tool for estimating liabilities. Having funds on hand reduces the pressure to make hasty trades purely to meet tax obligations.
What simple questions can help me check whether tax is biasing my investment choices?
Ask yourself: (1) Would I still buy, hold or sell if my tax rate were 0%? and (2) Would I prefer to pay tax and make a profit, or pay no tax and make a loss? If your answers change because of tax, you may be letting tax distort your decisions.
Why is paying tax sometimes a sign of investment success, and how should that affect my strategy?
Paying tax is a natural consequence of making money. Successful investors focus on buying underpriced businesses and selling overpriced ones — not on avoiding tax. Accepting some tax bills in pursuit of profits typically leads to better long‑term portfolio returns than chasing short‑term tax benefits.
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