Direct Investing: A Tool for the Little Guy, Too

The Dow Jones Industrial Average was up 18.4% in 2021. Direct investors in the Dow, depending on
their stock basis, could enhance after-tax returns by selling Disney (down 14.5%) at the end of the year.

Experienced investors know that it's difficult to be a stock-picker, i.e., be smart or lucky enough to buy individual stocks that will consistently outperform the market. Consequently almost everyone's porfolio includes index funds, which earn market returns.

Now there's a tool called direct investing that provides the diversification of index funds while adding tax enhancement: [bold added]

The tactic involves buying the underlying securities of an index, such as the S&P 500, then selling the stocks that decline. In a good year, investors capture the gains of the chosen index while creating losses that at tax time help offset capital gains, thus helping them keep more of their profits...

Terry Burnham, a finance professor at Chapman University, co-wrote a paper that studied the effectiveness of tax-loss harvesting on a portfolio of the 500 largest U.S. common stocks by market capitalization from 1926 to 2018. It calculated that a person who continued to invest in the portfolio each month using a tactic akin to direct indexing would have improved after-tax returns by 1.08 percentage points annually compared with just owning the portfolio and not tax-loss harvesting. The calculation assumed a long-term capital-gains tax rate of 15% and a short-term rate of 35%.

The direct investing technique had been uneconomic for non-wealthy investors. The commissions on buying, say, all the individual stocks in the S&P 500 and selling those that had tax losses would have resulted in high transaction costs; just holding an S&P 500 index fund would have been better. But that was then.

Software-management costs and brokerage commissions have now fallen to zero or near-zero to make direct indexing feasible. Also, the ability to own fractional shares ("stock slices") makes the strategy workable even for small investors.

The technological revolution in finance helps the little guy, too.