Ready For Retirement
Ready For Retirement
How Should You Invest $10M+? Most Underutilized Strategy Revealed
Direct indexing, an advanced investment strategy, allows investors to own individual stocks within an index instead of a mutual fund or ETF, offering greater control and flexibility. This approach is particularly valuable for tax-loss harvesting, where selling underperforming stocks and reinvesting can offset gains and reduce taxes without losing market exposure.
Ideal for high tax brackets, concentrated stock positions, or charitable giving, direct indexing can boost returns by 0.5%-1.85% annually over decades, a benefit known as “tax alpha.” Once reserved for ultra-wealthy investors, advances in technology now make it accessible to portfolios starting at $500K. However, success requires sophisticated tools and tax expertise, making it a powerful strategy for the right investors.
Questions answered:
1. How can direct indexing and tax-loss harvesting improve investment returns without increasing risk?
2. Who benefits most from using a direct indexing strategy?
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Timestamps:
0:00 - The strategy - direct indexing
3:57 - Tax loss harvesting
7:22 - More than locking in losses
9:36 - The research
11:38 - An involved process
13:05 - Criteria 1, 2, and 3
17:04 - Criteria 4 and 5
19:52 - More accessible due to technology
Create Your Custom Strategy ⬇️
If you have $10 million or more in your investment portfolio, then you need to seriously consider the investment strategy I'm going to be talking about today. And if you don't quite have $10 million, I still want you to watch, because there's some principles here that you can apply to any situation. What I'm going to specifically do is walk through the five criteria to help you understand if this specific strategy will work for you. So what I'm going to do today is number one go over the strategy I'm talking about to show you how it works. Number two show you very specifically what the benefits are in very real, tangible numbers. And then, finally, number three I'm going to talk about the five criteria that you can look at to see will this strategy work for you. So let's jump right in.
Speaker 1:This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Let's start by comparing this to a traditional investment, and let's say the S&P 500. Now, with the S&P 500, it's just an index. An index means you can't invest into it directly. What you do is you might buy a mutual fund or an ETF that tracks the components of that index. For example, in the S&P 500, there are 500 different companies represented in that index and they're weighted based upon their market cap, which means the bigger the company, the more of that index weighting that company is going to have. So, using the S&P 500 index as an example going all the way back to 1926, the S&P 500 has returned about 10% per year. Now you can see this graph right here that if you get 10% per year, $1 turns to well over $14,000 over that time horizon. Now I don't care if you have $10, $10 million or $10 billion. A 10% annualized return is an incredible return and if you could get that long-term a of your goals, you're probably going to be right on track. For and here's the thing as incredible as those returns are, if you're investing outside of an IRA or 401k or Roth IRA, you can do even better when you factor in the strategy that we're going to talk about, and you can do even better without taking on additional risk or even changing your holdings all that much. Let me show you how.
Speaker 1:So the S&P, as I mentioned, the S&P 500, it's just a collection of 500 individual component companies and, as I mentioned, over the past hundred years or so, the S&P 500 has averaged 10% per year. What that does not mean is it does not mean that each of those 500 individual component companies has also averaged 10% per year. In fact, it's been quite the opposite. Specifically, when you look at it on a year-by-year basis, for example, in 2023, the S&P 500 was up about 26% on the year. Does that mean all 500 companies within the S&P 500 were up 26% on the year? No, nvidia was the best performer in the S&P 500. It was up 193%. Meanwhile, the worst performer in the S&P 500 for 2023 was Enphase Energy. It was down 50%. So, as you can see, there's a very wide range of potential returns between the best performer and the worst performer, and the average was 26%. Even in a year like 2022, the year right before it, the S&P 500, on average, was down 18%. But if you look at its individual components, the best performer, which is Occidental Petroleum Corporation, was up about 119% and the worst performer, generac, was down 71%. So the specifics of this aren't important. All I'm trying to illustrate is that you have an average return in the S&P 500. But if you look at the component parts, the best performer compared to the worst performer is typically dramatically different.
Speaker 1:So here's the concept what if, instead of just owning an S&P 500 mutual fund or just owning an S&P 500 ETF, you owned each of the individual components? So Apple, for example, represents about 7% of the S&P 500. If you put a million dollars into an investment portfolio and, instead of buying a million dollar S&P 500. If you put a million dollars into an investment portfolio and instead of buying a million dollar S&P 500 ETF, you would put $70,000 into Apple, because that's seven percent of the whole. Then you go down the line every single company within the S&P 500, to the point that you owned each individual component. So your overall allocation was the exact same as an ETF or a mutual fund that tracked the index, but you owned 500 companies as opposed to just one ETF, which gave you exposure to each of those 500 companies.
Speaker 1:Now you might be saying, james, I've heard of this. This is called direct indexing. I'm way ahead of you. Yes, that is what it's called. That's one term for it. But that's not where the magic is. That's not what makes this special.
Speaker 1:What makes doing this special is when you overlay it with a few other things I'm going to talk about in just a second, but to start, I want to make sure I'm clear about how the strategy works, which is, instead of just owning an ETF or a mutual fund which can be great and it can actually be ideal in some ways we're going to instead own the individual components and we're going to talk about why this might be ideal in other cases. So here's one of the first benefits of doing this it doesn't do you any good just to own 500 individual components instead of just owning one ETF. All you've done at that point is increase your complexity more stuff to track, more stuff to take care of. If that's where you start and end just owning the components as opposed to the ETF you probably haven't done yourself much good. In fact, maybe it's actually worse for you because of how much more it takes to track and to manage that.
Speaker 1:However, what a direct index approach, what a separately managed account approach does is? It says now you can take full advantage of some pretty robust tax loss harvesting opportunities. What is tax loss harvesting? Tax loss harvesting says look, when something is down in value, what if we sell it and we lock in a loss? You may say well, you never want to sell and lock in a loss that's bad to sell? Don't we want to recover and participate when the market grows again? Of course we do. That's why, instead of just selling it and staying out of the market, you sell the stock, you sell the fund, you sell whatever it is. You wait 31 days to avoid any wash sale rules and then you repurchase that security, and even in the meantime, you might repurchase a similar security that's not identical or the exact same. In doing so, what you've done is you've continued to participate in market growth over time, but you've locked in losses as they've presented themselves. You've locked in losses that you can use to write off against ordinary income up to a certain limit each year, or you can write it off against other gains from stock sales, business sales, real estate sales, et cetera.
Speaker 1:So you look at a year like 2022. Well, 2022 is not a great year for the S&P 500. So if you had invested in the component pieces or even just the ETF in that year, you could have harvested about 25% in losses that year. That means a million dollars put into the S&P 500, you could have harvested $250,000 or so in losses that you could then use to write off against other gains, either in that same year or in future years, when those gains are realized. So that makes sense in a year like 2022 when everything's down.
Speaker 1:What about a year like 2023? 2023, the S&P 500 was up 26% and in fact it never dropped below 0.8% where it started the year at, and that was on January 5th. On January 5th of 2026, the S&P 500 was about 0.8% lower than it was at the beginning of the year. From there on out, it was nothing but gains. So how do you harvest losses in a year like that where everything's up? Well, if everything is just in one ETF or one mutual fund, you really can't. You could have made that trade on January 5th to lock in a very small loss. But if you're owning all the individual components via direct indexing, via a separately managed account or an SMA, you're going to have the flexibility and, more importantly, the opportunity to sell a lot more. As I mentioned, enphase Energy was the worst performer that year. It was down 50% even though the S&P 500 was up more than double digits on the year. So when you're owning the individual component parts, you have far more opportunity to add a granular basis at an individual stock basis. Say, can I harvest losses here while still taking advantage of the market upswing throughout the course of the year? So in just a minute here I'm gonna quantify what the benefits of this are and then I'm gonna walk you through again the five criteria that you can use to determine does this make sense for you? But criteria that you can use to determine does this make sense for you? But before I do that I want to make sure I'm crystal clear about one thing Tax loss harvesting is far different than just selling an investment because it's down to lock in the losses.
Speaker 1:If all you do is sell an investment when it's down to lock in the losses and you never do anything with that, you've lost, you're down, you're locking in a loss and you get to use that as a tax write-off, but you're missing out on whatever gains come from there on out. The difference between that and tax loss harvesting is tax loss harvesting is harvesting these losses with the intent to as soon as possible so 31 plus days later get back into the investment or even sooner, get back into a very similar investment, so you don't lose your exposure when the market does start climbing again. So it's designed to be a way to say, can we still participate in the growth but harvest losses along the way? Start taking advantage of these losses. And here's the beautiful thing about these losses these losses, you don't have to use them this year. For example, if I know that I'm going to sell a business in a few years, I'm going to sell a piece of property in a few years, or I have a big unrealized gain in a significant stock position, I can start realizing losses along the way. I can realize some this year, I can realize some the following year, I can realize some in subsequent years beyond that, and I can start banking those. This is a growing bank of losses that I can use so that when I sell something a business, a stock, a piece of real estate I don't have to get hit with a huge tax bill because I have losses that I can use to offset against that. So that's how the strategy works.
Speaker 1:It starts with a direct index or starts with a separately managed account that owns the individual stocks, as opposed to just an ETF or mutual fund that's got a wrapper around all those individual stocks. And then, number two, you use that to apply some pretty aggressive tax loss harvesting. Now what are the benefits? You know this sounds good, but is this just theory, something that maybe sounds good but it doesn't actually do anything for you when you actually look at different market environments. That's the question. I don't care how good something sounds, you want to test this. You want to have a pretty robust data-driven way of saying does this actually add value? And so I'm going to link to a paper below here, and this paper is where a lot of this research is based upon. It's done by Dimensional Fund Advisors, and what that paper does is it takes you through three distinct time periods 1990 to 2000,. 2000 to 2010,. 2010 to 2020. All were very different market environments. Some had a lot of ups, some had a lot of downs, some had a mix of both.
Speaker 1:But when you look at that, depending upon your situation, your tax bracket, whether you had outside gains, whether you did some charitable giving, whatever the case might be, depending on the situation you could gain anywhere between half a percent and 1.85 percent per year in this study, in what you might call tax alpha, tax alpha being what are the additional returns you're getting, not just because of the investments not even the investments themselves at all but the tax benefits of approaching your investments with the right tax management strategy. Again, I mean, it's not just saying, hey, we have this great investment portfolio that's going to grow over time, but can you apply a tax strategy on top of that that yields even more in net gains to you when you factor in the tax benefits? And, by the way, this doesn't have to just be with the S&P 500. I'm using that as an example, because all of us probably know what the S&P 500 is. You can do this with small companies. You can do this with a total US market approach. You could do this with international companies. Now, typically, there's some reasons to avoid that because of costs associated with trading individual stocks on international markets, depending on how you're approaching it. But this is to say that this is an approach that isn't just limited to the S&P 500. Meat-sized companies, small companies, large companies, value companies, growth companies, total US market it doesn't matter. This was just an example that I used, but you can take this approach and overlay it to investing in any specific asset class or sector that you're looking to accomplish this with. Here's the thing, though these gains can be incredible. Talk about half a percent per year to 1.85 percent per year. That is in no way a guarantee that that's going to happen going forward. That's simply saying, if you look at the study, which again there's a link to in the resources below, this study shows that over these three decades that was the average potential return if you're in the highest tax bracket here and if you're meeting some other criteria, so when you look at that, those are gains. That's tax alpha that you can't just ignore if you want to do the best you possibly can within a brokerage account. Here's what you need to know, though this isn't as simple as saying, ok, I'm going to go on to my E-Trade account and I'm going to buy all 500 stocks in the S&P 500 and do this myself.
Speaker 1:This takes an incredibly robust process. It requires three things. Number one it requires a daily trading system that has the capabilities to look at hundreds or thousands of different stocks each day to look for potential tax loss harvesting opportunities. Number two it requires extremely detailed tax sensitivity. It's not enough just to sell a stock at the right time. How do you wait the required time period before you can repurchase it? How do you coordinate between what's happening in your brokerage account and other accounts so you don't violate any wash sale rules? There's extremely detailed tax sensitivity that's required to do this and do this effectively. And, finally, it requires a sophisticated trading platform that's proposing the right trades, so that you're not having to go through each individual stock a hundred times over, a thousand times over to say when do I buy, when do I sell, what's the metrics that I'm using to do this? This is something that you're going to need pretty robust software to do, so this isn't a sales pitch to do in a specific way. As much as it is saying. This can be an incredible strategy for the right individual a no brainer strategy, in fact, for the right individual. However, there are some things that you need to know about doing this. It's not as simple as going and purchasing an S&P 500 ETF. It requires a much more robust process. But if you do it right, the benefits the half a percent per year to 1.85% per year that the study references the benefits can be substantial, especially when you compound those over years and years and years.
Speaker 1:So let's now talk about the five criteria of how do you know if this is right for you. I started the video saying hey, if you have $10 million or more in your portfolio, you should seriously consider something like this. What are those five criteria, though? $10 million is not a magic number. There's actually some more detailed things that you should be looking at to see if something like this might work for you, whether you have less or more than that $10 million number.
Speaker 1:The first criteria that you should look for is if you're in the highest tax bracket. If you're in a very low tax bracket, tax loss harvesting doesn't do much for you. You already might be in a 0% tax bracket or a very low tax bracket, so it doesn't do you any good at tax loss harvest unless you have gains or future gains that you can use to write off those losses against. So the first thing that you want to look at is this is going to be most effective for people in the highest tax bracket. It doesn't mean if you're not in the highest tax bracket, you can't still use it. But in the higher tax brackets the higher you are the more you're going to get out of a strategy like this. The second criteria to look at to say will this make sense for you is for people who have gains that are held elsewhere. Now you can have gains in your portfolio. That's certainly helpful just to use the losses from this strategy to offset the gains in the same portfolio.
Speaker 1:Where I see this being most effective is people who are selling real estate. People are selling a business. How can you use your portfolio to bank up losses to use to write off against that? For example, maybe you have $10 million in a separately managed account in this approach that we're talking about. Well, if you could harvest a couple million dollars in losses over the next couple of few years and you know that you're going to be selling a business for $3 million three years from today, well, that $3 million assuming it's all treated as a long-term capital gain that's significant. But if you have, let's say, a couple, couple and a half million dollars of losses that you've been harvesting along the way, those losses can be banked up, can be saved, so that when you sell your business for $3 million, instead of paying taxes on $3 million, well, if you have $2.5 million of losses that you've harvested, those are written off directly against the sale of your business. So you still might have a $0.5 million net gain in this example, but that's a whole lot easier to afford than it is on a $3 million gain. So, people who have real estate, who have businesses who have other accounts that are generating gains, whether these are short-term or long-term gains. Those types of situations are where this type of a strategy can do wonders, not just in terms of minimizing the taxable gains within the account itself, but also minimizing the net gains across your overall financial strategy.
Speaker 1:The third instance in which this type of a strategy might make a lot of which this type of a strategy might make a lot of sense is people of high degrees of concentrated stocks. This is typically if you're an executive of a company, or maybe you've been working at NVIDIA for a few years and you've received stock options and those stock options have absolutely skyrocketed. And now you look at your portfolio and you've done well, but NVIDIA represents 90% of your net worth 95% of your net worth, for example. Well, if you're going to open up a different investment account to diversify, as of this recording, nvidia represents 6.7% of the S&P 500. So if you say, okay, I'm going to use my bonus, I'm going to use some cash that I have to buy the S&P 500 to diversify, well, you're diversifying, but again, you're putting 6.7% more into NVIDIA and you already have a large concentration of that. Just using NVIDIA as an example because it's done really well. So anyone that's had stock options or has purchased that probably has a high concentration in that stock if they still own it. But this can apply to anything Apple, nvidia, nike, any stock that you have. If you're an executive or if you have a high concentration there, you could use a separately managed account because you now have control over the individual components. You could say you know what, with this separately managed account, with this money here, I'm going to track the S&P 500. I'm going to track the total US market, but I'm going to exclude any new purchases of NVIDIA. That 6.7% that would have gone back into NVIDIA. If I'm just tracking the S&P 500, I'm going to take that and I'm going to diversify it elsewhere. I'm going to spread it out everywhere else, so I'm not adding to the concentration that I already have. So people that have high degrees of stock concentration, this can be a wonderful strategy to help diversify and not add on to the holding that they already own.
Speaker 1:The fourth instance where it might make sense to use a separately managed account is when you want to engage in value investing. Say, for example, you don't want to own any tobacco companies. Well, if you just buy the S&P 500, you can't tell that manager don't buy these companies. I don't want to put my money in companies that sell tobacco products, for example. You can't do that. But if you own a separately managed account, let's assume again that you're just tracking the S&P 500. To assume again that you're just tracking the S&P 500, you can, at your own discretion, exclude sectors, exclude specific companies, include the types of companies that engage in specific types of businesses. You have full control to make this what you want. So if you don't want your money to support certain companies, to support certain institutions or causes, you have the flexibility to do that with a separately managed account. That you don't when you're just owning the entire market.
Speaker 1:And then, finally, the fifth instance where this type of a strategy makes a lot of sense is when you do a lot of charitable giving. So here's the reality of a separately managed account. If you're constantly harvesting losses, what that means is you're going to have a lot of unrealized gains at some point. Now, net, net. The benefits are still tremendous. But where the benefits get even better is if you do a lot of charitable giving. And here's why.
Speaker 1:Let's assume that with this separately managed account, you bought NVIDIA again a few years ago. Well, you bought it for $1,000, and now that $1,000 is worth $10,000. Well, if you're going to do charitable giving and you've traditionally been giving cash, that $10,000 cash wonderful, you're not doing it just for the tax deduction, but it's costing you $10,000. What if, instead of gifting with cash, you gifted with appreciated stock? I'll go back to that NVIDIA example. You have $10,000 of NVIDIA stock that you purchased for $1,000. Well, if you're in the top tax bracket and you live in a state like California, that $10,000 doesn't represent $10,000 to you because as soon as you sell it, you're paying taxes at the highest federal bracket and you're paying taxes at the highest California state tax bracket. Of that $10,000, if you were to sell it, you're probably paying about $3,200 in taxes, which means that $10,000 to you is really only worth about $6,800. So here's the thing If you're going to be donating $10,000, don't do it with cash.
Speaker 1:Do it with this appreciated stock. Gift the $10,000 of NVIDIA stock, you get the tax deduction for the full $10,000. The charity doesn't pay taxes when they receive it, and now it's a win-win. Ideally, you've been receiving the benefits of the tax strategy along the way, and now, if you're gifting the appreciated securities, it's not like you're just kicking the tax can to the future. You don't pay any taxes on that and you still get the deduction for it. Now, there are some rules around how much you can deduct when you're gifting securities or appreciated assets. So talk to your financial advisor, talk to your tax preparer, to make sure that you're following the rules on that. But that's one approach where this can be a win-win Harvest losses along the way to write off against gains from self-stocks, businesses, real estate, and then, as those assets appreciate, you're gifting them. So those are five criteria that you can look at to say does this type of a strategy help you?
Speaker 1:Now, why don't more people do this? Well, number one this used to be reserved for people who had 20 million plus dollars. You couldn't get something like this because of how robust the trading platform had to be, because the team needed to do it Unless you were ultra high net worth. You just didn't have access to something like this. As technology has grown, as technology has become far more effective, these types of strategies are available to people with a lot less in their portfolio the one that I'm talking about, for example. So the dimensional funds white paper below. The minimum on that used to be $20 million 20 plus years ago. The minimum now is $500,000 because technology has gotten to the point that it can allow for this to be an effective solution for people with a lot lower portfolio balance.
Speaker 1:But you have to have an incredibly robust process to be able to manage this. Like I said, you're not going to go to E-Trade, open an account and do this just submitting manual buy, sell orders. You need a system, you need an approach that, if this is something that you're looking at, you say, oh my goodness, that's absolutely something I should consider. I meet one, two, three, four, maybe all five of those criteria that James talked about. If you meet those criteria, the potential benefits are substantial. To reiterate one more time half a percent per year to 1.85% per year is what the study below found when studied over a 30-year time period, in terms of the tax alpha generated by this.
Speaker 1:So, once again, what does that mean? It means you're not taking more risks. It means you're not changing your investment strategy. It means you're overlaying the right tax strategy on top of an already robust investment strategy to, say, get the gains that this type of strategy can produce for you in terms of market growth, but have the tax overlay to harvest the benefits of that as well. So if any of that describes you, if any of that describes your situations, I walk through these criteria and you're saying how on earth do I get to be able to do something like this? Reach out to us at Root Financial. So I'm the CEO of Root Financial. If you click on our website below, wwwrootfinancialcom, you can click on start here and see if we might be a good fit to work together. But as you look at this, this is a process, this is a system that, if you have a substantial net worth, you've done a lot of work to get there. Make sure you're using the right strategies to maximize what you have so you can get the most out of that and ultimately use that to get the most out of life with your money as a tool to get there.
Speaker 1:Root Financial has not provided any compensation for and has not influenced the content of any testimonials and endorsements shown. Any testimonials and endorsements shown have been invited, have been shared with each individual's permission and are not necessarily representative of the experience of other clients. To our knowledge, no other conflicts of interest exist regarding these testimonials and endorsements. Hey everyone, it's me again for the disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner.
Speaker 1:Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
