How We Invest

The Global Market Portfolio is the starting point for all client portfolios. It is then tailored to fit the client’s situation, including risk preferences, factor investing, and tax status. Most client portfolios contain some combination of all of these, to varying degrees. Here is a primer on the dividend-avoidance strategy.

Tax Planning 101

The goal of Tax Planning 101 is to escape tax altogether, forever. As Professor Edward McCaffery details in The Oxford Introduction to the U.S. Income Tax Code, Tax Planning 101 consists of three steps.

Step One: Buy assets that increase in value without producing a cash flow

In other words, a diversified portfolio of stocks that don’t pay dividends. This is the subject of an entire chapter in my book, The Overtaxed Investor.

Alas, nearly all other investments generate a cash flow, leaving taxes to gnaw away your total returns. The money lost to taxes never compounds to produce greater wealth for you. The financial services industry has set up a conveyor belt that feeds your investment returns to the Internal Revenue Service.

When you buy stocks or funds in an IRA or 401(k), the government is your silent investment partner. It owns the percentage of your account set by your marginal tax rate at the time of withdrawal. As your required minimum distributions ramp up, your dividends and capital gains will be taxed as ordinary income at your higher marginal rates. This is not Tax Planning 101.

Alternatively, when you buy index funds, mutual funds, or exchange-traded funds in a brokerage account, you cannot credit any of these funds’ internal tax losses against ordinary income or your other capital gains. In a typical down year, shareholders despair and sell their mutual funds. These reckless investors leave the remaining owners stuck with the tax tab they created. Sensible buy-and-hold investors are left holding the bag. Is that fair?

Meanwhile, the dividends in your brokerage account pile up. Once again, the government is your investment buddy. In California, high-bracket investors pay up to 37.1% tax on dividends and capital gains year after year. This is also not Tax Planning 101.

Our process starts by screening out all the stocks that pay dividends. We carefully select U.S. companies for the characteristics that academic research suggests are the most desirable to long-term, buy-and-hold, tax-sensitive investors.

Inside your account, as your holdings compound, they do not generate a taxable income stream. Unlike with mutual funds, there is no portfolio churn from active managers or index changes or trigger-happy co-investors to gin up capital gains for you to pay. You have effectively fired Uncle Sam, your investment buddy. This is Tax Planning 101.

This portfolio also works well for children subject to the “kiddie tax.” Once a child’s unearned income passes $2,700 (the 2026 threshold), the excess is taxed at the parents’ rate. A portfolio that pays no dividends never gets there.

Your account goes beyond this into Tax Planning 102, because we routinely harvest capital losses on your behalf. You can apply these against capital gains and/or against $3,000 of ordinary income every year. These losses can be carried forward indefinitely.

Will eliminating dividend stocks impair investment performance? The stocks for this portfolio are selected for investment styles evidencing long-term structural alpha in the academic literature. That said, investors follow fads and there is no guarantee that the short-term performance of these companies will closely follow any market index. Care is exercised in selecting the individual companies, in weighting the holdings, and in timing their purchase to make this an ideal holding for a long-term, tax-sensitive investor.

Step Two (optional): Income from a Zero-Dividend Portfolio

Since your account holds numerous individual securities rather than a fund, we can cherry-pick the highest-basis lots to sell when you need cash. Research by John Birge and Song Yang shows that a portfolio holding numerous individual securities – even ones with a cost basis of zero – can be liquidated at 3% to 7% a year and still postpone any capital gains taxes for ten to fifteen years.

You will read that the truly rich do something else: they never sell; they borrow against the portfolio, and the loan comes to them tax-free. This is true. However, it is essentially useless advice for anyone who is not a billionaire. A portfolio loan is only tax-free so long as it never has to be repaid, and it only never has to be repaid if the collateral is large enough relative to the loan value that no bear market can ever trigger a margin call. Stocks fell by roughly half in the 1970s and again in 2008, and by three-quarters from 1929 to 1933. For a family borrowing against $10 million rather than $10 billion, the loan-to-value ratio goes out of whack precisely when selling to repay it hurts most. “Buy, borrow, die” works for the people it was named after. For everyone else it is “buy, borrow, get a margin call, sell at the bottom.” Not recommended.

Step Three: Eliminating Capital Gains

Deferring the tax liability on capital gains allows them to grow undiminished to the investment horizon. This is tantamount to a free loan from the Internal Revenue Service. The larger and longer the deferral, the greater the after-tax benefit to the investor. This means any portfolio rebalancing must be done with extreme tax-awareness.

Want more? If you leave the assets in your estate, your unrealized capital gains liability disappears entirely. Your appreciated stocks receive a step-up in cost basis. Your executor can sell the stocks and pay no capital gains. Your heirs are free to restart the process. In the unlikely event that Congress changes the tax code to eliminate the capital gains reset to fair market value, you will have benefited from possibly decades of tax deferral.

What we don’t do

Every few months the Wall Street Journal seems to lionize a new investment structure that promises to make taxes disappear: an ETF that turns Treasury-bill interest into deferred capital gains, a fund that lets you swap appreciated stock into a diversified portfolio without recognizing capital gains, a leveraged long-short strategy that manufactures capital losses on demand. Each is clever. Each is also built on the assumption that the IRS will honor the form of a transaction rather than its substance.

That is not a safe assumption. Substance over form, the step-transaction doctrine, and the economic substance rule are among the oldest and best-established principles in tax law, and they exist precisely to unwind arrangements whose only real purpose is the tax result. The structures in the headlines have not been tested against them. They may survive. They may not. And if they don’t, the people who find out will be the clients who bought them – via a letter from the IRS, years later, reassessing returns their investors assumed were closed.

I ask myself, why doesn’t Warren Buffett – with his encyclopedic knowledge of the tax code and billions of dollars of cash and unrealized capital gains on the balance sheet – use these strategies to save money for Berkshire Hathaway’s shareholders? Here is the greatest investor who ever lived, a man who watches every nickel, and who has a fiduciary obligation that he takes very seriously. I asked him why he keeps all his cash in T-bills when he could do better by investing it differently. He replied, “It’s because I have more money than sleep.” He prefers to invest safely so he can sleep soundly.

Everything we practice – buying assets that appreciate without cash flow, selecting which lots to sell, harvesting losses, and holding to the step-up – has been settled law for decades. Nothing we recommend in The Overtaxed Investor depends on the IRS overlooking anything. There is no letter coming. That is the point.