It doesn’t seem like there should be seasonality in investing—after all, businesses are businesses and their cycles (generally speaking) don’t change from one year to the next. Retailers look forward to Black Friday, restaurants fear February, tax preparers make way more money every March and April than they do in July.
These things are known, therefore in theory the stock market (again, generally speaking) shouldn’t respond much to them. Stocks should respond much more to surprises than they do to things that are expected to happen.
And yet, the stock market can have a seasonality to it. We all know about the "October Effect," and the past above-average volatility for that month. But perhaps less publicly understood is that October 31 is generally, but not always, the end of the tax year for many registered investment companies, which include mutual funds. Have the cumulative tax-loss decisions during that month for these companies, which combined can account for trillions in assets, created some of the volatility for which historically October has been known? Sure, possibly.
For individuals, the tax year ends at the stroke of midnight on December 31. This means that December is the last opportunity that investors have to make really tough decisions that would serve to increase or decrease their tax bills in 2025.
Making investing decisions based on tax considerations, to me, is the tail wagging the dog. That said, taxes are expenses, and expenses are permanent reductions of capital employed. I think people underestimate this, not so much because a realized expense represents cash removed, but because that cash removed reduces the fuel upon which a portfolio can compound. It’s why people who wanted to sound really smart attributed the quote "Compound interest is the eighth wonder of the world" to Albert Einstein. (Oddly enough this quote, for which there is no proof he said, is much more well known than the one at the top of this article, which he did say).
December offers a chance to set up your portfolio for potential longer-term success. Tax efficiency is a short-term win (in the same way that second helping of Thanksgiving mashed potatoes was a short-term win) which I believe should not be made if it is borrowing potential from the long term. You should be able to offer a rationale for each component of your portfolio why it has your confidence that it will compound over the long term.
So while you are in the process of making decisions about limiting your general tax exposure through transactions, you might also consider ones that have no tax benefit at all. A position that—whether it has done well or not—gives you little confidence that it will compound long term is not one that I feel should remain in your portfolio, tax consequences be damned. (Though any tax-generating decisions, once made, can of course be pushed into early 2026!)
We think about the nature of mistakes all the time here at Motley Fool Asset Management. In so many cases, mistakes tend to come from overweighting the short-term impact of a decision (or lack thereof) over the consequent impact over the longer term. You see it with investors, and you see it with companies as well: shrinkflation, cookie jar spending decisions to project a vitality that doesn’t exist, poorly-considered capital decisions like mergers to cover up weak profits, the list is endless.
Incidentally, one of the brilliant features of exchange-traded funds, like those managed by Motley Fool Asset Management, is that they are hardwired to take advantage of a provision in the tax code that can make them quite tax-efficient. ETFs are designed to take advantage of a little piece of tax law sorcery, Section 852(b)(6) of the Internal Revenue Code, exempting the distribution of capital gains when appreciated shares are handed "in kind" to redeeming investors, allowing for tax-free compounding of both short- and long-term capital gains,—creating larger accumulated capital gains and allowing investors to defer taxation of such gains until an investor sells their shares.
Of course, "exempting the distribution of capital gains" is a different way of saying "accumulating capital gains," and of course nothing here should be viewed as individual tax advice. (Seriously. My tax advisor has as many questions for me as I do for him. Some of them are unkind.) But this tax-deferral feature of ETFs can be a powerful tool to give clients flexibility in when they realize their taxable gains. How big has the cumulative tax savings been? A study by the Harvard Law School Forum on Corporate Governance puts the cumulative annual tax savings versus actively-managed mutual funds at 1.05% per year.1 Arguably, this general tax efficiency advantage of ETFs over mutual funds may likely be exacerbating the migration of taxable assets into ETFs from similarly situated actively-managed mutual funds.
And, just because something allows you to defer tax doesn’t mean that it is free. In-kind redemptions have a friction that, unlike taxable gains and losses, investors don’t see but still have an impact on shareholder returns. In fact, perhaps counterintuitively, an occasional capital gain distribution in an ETF may be a sign that the advisor is highly client-focused ,since it can mean that they have analyzed the relative costs of an in-kind distribution versus direct in-the-market sales and determined that the latter is more shareholder-friendly, even though it is much more visible.
These are the kinds of questions that come up this time of year. So while December is a prime time to take advantage of tax optimization, the primary goal for investors should be to maximize portfolio optimization. These concepts may be closely related, but they are not the same thing.
So as we deck the halls this holiday season, let’s take the opportunity to clean the decks as well. Consider eliminating strangers in your portfolio, positions that no longer give you confidence, and also, taking advantage of whatever opportunities the Internal Revenue Code offers to lower your tax bill.
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