Tax-Loss Harvesting (TLH) is a popular, sophisticated strategy that turns market drops into a positive tax event. By selling a losing investment, realizing the capital loss, and immediately buying a similar, non-identical asset, you lower your current tax bill without materially changing your market exposure. It sounds like free money—and for high-income investors, it often is. However, there is a key behavioral and market risk that automated algorithms rarely account for.
“The real risk in TLH isn’t the IRS’s ‘wash sale’ rule; it’s the psychological relief that comes with officially realizing a loss. It can anchor you to negative sentiment.”
The automated TLH strategy requires you to sell one ETF (e.g., VOO) and immediately buy a similar one (e.g., IVV) to avoid the 30-day Wash Sale Rule. The problem arises in the period after you make the replacement. If the original asset (VOO) suddenly rips higher than its replacement (IVV) during the time you wait to repurchase the original, you’ve missed out on the higher gain. While minor differences are expected, in volatile markets, this slight divergence can cost more than the tax deduction saved. This is a risk of tracking error introduced by the strategy itself.
Conclusion (Paragraph Block)
TLH is a brilliant tool, but it’s a trade-off. You are exchanging a certain tax benefit for a small, uncertain risk of tracking error and a potential emotional drag from realizing losses. The benefit almost always outweighs the risk, but the strategy must be viewed as a calculated, non-zero-risk maneuver, not as a magical loophole.
