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This Is How Warren Buffett Is Playing Tax Reform. Should You Do the Same?

By Billy Duberstein - Updated Oct 27, 2017 at 4:56PM

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Is tax reform skewing the market?

As an investor who looks for great individual companies from a long-term perspective, I don't put too much stock in trying to predict the broader market. Constantly moving in and out of positions in an effort to profit from short-term trends costs the investor a bundle in commissions and capital gains taxes. That's why the best approach to investing in equities is simply to buy shares of great companies at reasonable prices and hold them for the long term.

That being said, when the Oracle of Omaha himself, Berkshire Hathaway (BRK.A 3.75%) (BRK.B 4.02%) CEO Warren Buffett, makes a comment about the broader market, I listen. That's not only because he's a genius, but also because he has a similar bottom-up, long-term investing philosophy. In a recent interview with CNBC's Becky Quick, he made a brief comment that made me sit up and listen regarding the potential of a large capital gains tax cut.

Warren Buffett

Image source: The Motley Fool.

Republicans in Congress are hoping to pass a capital gains tax cut as part of a broader tax reform package this year. The White House plan dropped the top capital gains tax, which is the amount one pays on profits from investments, from 39.6% to 20%, while the House of Representatives Plan calls for an even steeper drop to 16.5%.

Here's what Buffett had to say about the pending legislation's possible effect on the stock pmarket (emphasis mine).

WARREN BUFFETT: It doesn't happen very often that there's-- that you're in the month of October with a major tax act being-- a real possibility. Who knows whether it's a 20% chance, 50% chance? But one thing I know about it. I'll know the answer within a month or two. I mean, there-- there are not that many days left to legislate. And-- and-- and I would feel kind of silly if I realized a billion dollars worth of gains to pay 350 million of tax on it if just waited a few months and would have paid 250. Now, if enough people are doing that, that may mean that the market's being affected fairly substantially.

BECKY QUICK: Right. That's what the-- the-- what-- what-- what is the broader play in the market as a result? 'Cause if you're doing it, you've gotta imagine lots of people are doing it.

WARREN BUFFETT: I think that's true. I think that's true.

BECKY QUICK: You're talking about billions of dollars of potential sales.

WARREN BUFFETT: Well, maybe hundreds of billions here. I mean-- I mean-- and--. And you may be talking about people that-- it would-- it would tend to depress stocks that have behaved badly because people would be taking the losses now. And it would tend to defer gains and reduce the sellers currently that would be in stocks with very large appreciation.

A "tax reform rally?"

In other words, Buffett thinks many investors may be holding winners and selling losers in unusually high volumes right now. You may have noticed that the market has run up this year, with the S&P gaining more than 15% with dividends reinvested -- and that's on top of last year's 11% gain. High-quality growth stocks such as Nvidia (NVDA 5.55%) and Netflix (NFLX 5.03%) have continued their amazing runs, while many so-called "value" stocks such as Kroger (KR 1.51%) or IBM (IBM 2.62%) continue to languish. Even though Buffett (who owns a large stake in IBM) usually pays no attention to the short-term moves in the market, even he thinks the prospect of lower capital-gains taxes may be a contributing factor to this market dynamic.

SPY Year to Date Total Returns (Daily) Chart

SPY Year to Date Total Returns (Daily) data by YCharts

Still, what does this mean for you and your portfolio? If we get tax reform and you wait to sell winners, there could be a huge "stampede" to the exits come Jan. 1. While that may or may not happen, that is a risk you are taking by waiting. Buffett himself invests billions of dollars of his own money, and many of his longtime holdings have likely made enormous gains, so for both him and Berkshire, it may be worth it to wait. But unless you're managing huge sums of money and have some large gains or losses on paper, I don't think you should do anything different.

That being said, if you own stocks in a non-taxable account such as an IRA, you may want to take the opportunity to rebalance your holdings today by taking profits in your winners and buying the stocks have underperformed (assuming you still like these companies' prospects), since you will not be affected by the (potential) tax change.

For most readers, however, sticking by the principles of buy-and-hold investing is still the way to go. If you've bought a portfolio of high-quality companies, it will pay off to hold them for the long run, regardless of whether the government passes some tax reforms this year.

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Stocks Mentioned

Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$417,401.43 (3.75%) $15,101.43
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$278.28 (4.02%) $10.76
Netflix, Inc. Stock Quote
Netflix, Inc.
$190.85 (5.03%) $9.14
International Business Machines Corporation Stock Quote
International Business Machines Corporation
$142.06 (2.62%) $3.62
The Kroger Co. Stock Quote
The Kroger Co.
$48.45 (1.51%) $0.72
NVIDIA Corporation Stock Quote
NVIDIA Corporation
$171.26 (5.55%) $9.01

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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