Why you should not be obsessed with taxes while investing?

Tax planning forms one of the bedrocks of your financial plan. That is definitely one side of the argument. But what you also need to understand is that your investment decisions cannot be driven purely by taxes. When you allow tax considerations to drive your investment decisions you are more likely to make sub-optimal investment allocations. Let us look at 3 such case studies where a focus on tax benefits tends to distort your asset allocation. In the process it endangers your long term investment goals.

Case 1: Using dividend yield as a criteria for investing
It is quite common among investors to use dividend yield as a key criteria for investment. The argument is that since dividends are tax-free, a dividend yield of 5-6% will make the stock more attractive than a risk-free debt instrument. Therefore, the dividend yield argument is used as a proxy for a price below which the stock is unlikely to fall. The logic is that since the post-tax dividend already compensates for debt yields, any capital appreciation on the stock is icing on the cake.

Why tax obsession can be flawed in this case
If you historically look at high dividend yield stocks these are stocks that do not have sufficient growth opportunities or where there are structural problems. For a long time, we have had PSU banks and upstream oil companies that gave attractive dividend yields. In both these cases there were structural problems. While PSU banks were sitting on a mountain of NPAs, the upstream oil companies were hit by weak oil prices. In such cases, growth and capital appreciation is going to be hard to come by. What you may appear to gain in the form of post-tax dividend yields you tend to lose due to limited capital appreciation opportunities. Allocating money to such stocks purely for the dividend yield will be a sub-optimal use of your money.

Case 2: Holding on to stocks for the sake of LTCG tax benefits
This is a common dilemma that most of us tend to face. You have purchased a stock that has appreciated by nearly 40% in the last 8 months. Your target return of 30% has already been met. But your contention is that if you book profit now it will be treated as a short term capital gain and therefore will be taxed at 15%. On the contrary, if you hold the stock for another 4 months it will become a long term capital gain and therefore it becomes tax-free, thus enhancing your post-tax returns.

Why tax obsession can be flawed in this case
One of the basic rules in investing is that, “If something is too good to be true, then it is probably not true”. That specifically holds true for equities. You had targeted 30% in one year but the stock has appreciated 40% in 8 months. If you book STCG today and pay 15% tax, you are still going to earn 34% post-tax returns. This is more than your annual target return for the stock. Of course, if you have a fundamental conviction in the stock and want to hold it longer then that is a different ball game altogether. But holding on to a stock purely for the tax benefit is not acceptable. Four months is a long time in stocks markets. For all you know, you could see all your profits eroding in the intervening period.

Case 3: Adding on to your concentration risk purely to save tax
This is a common challenge in case of stocks in sectors that have done extremely well in the markets. Take the case of downstream oil! These stocks appreciated by over 120% between Feb 2016 and December 2016. That would mean two things. Firstly, it will mean that if you exit the stock then you will end up paying STCG on these profits. Secondly, these were high dividend yield stocks and you will end up losing on the benefit.

Why tax obsession can be flawed in this case
Once again, tax obsession is not the answer. If the price of downstream oil shares are up by 120% in 1 year and the other sectors have underperformed the Nifty, then your exposure to downstream oil would have gone up substantially. The first question you need to ask yourself is, “Whether your exposure to downstream oil in value terms has gone up way beyond your original allocation goal”. If the answer is “Yes”, then you just need to trim your exposure to downstream oil stocks. Then it does not really matter whether you are losing out on the dividend yields or whether you are going to end up paying higher rates of STCG. The sanctity of your portfolio is more important than tax considerations like tax-free dividends and LTCG.
The moral of the story is to never let taxes drive your investment strategy. Tax is supposed to be incidental to your investment decision and that is the way it should ideally remain!