The Achilles Heel of the Magic Formula

If there is one major flaw in the Magic Formula, it is taxes. The strategy requires an annual portfolio turnover of close to 100%. Because you sell your entire basket of 20 to 30 stocks every year, you constantly trigger taxable events.

If you are not careful, the outperformance you fought so hard for will go straight to the tax authorities. Transaction costs and taxes are among the key risks we cover in the dark side of the Magic Formula. Here is how to handle your portfolio in a tax-smart way.

Understanding the Greenblatt Tax Trick

In the United States, the tax code heavily favours long-term investing. If you hold a stock for less than a year, you pay short-term capital gains tax (which equals your normal income tax bracket). If you hold it for more than a year, you pay a much lower long-term capital gains rate.

Joel Greenblatt designed a clever workaround for this in his book:

  1. Sell the Losers Early: Sell the stocks that have dropped in value a few days before the one-year mark (e.g., at 360 days). This locks in a short-term capital loss, which can be used to offset other income.
  2. Sell the Winners Late: Sell the stocks that have gone up a few days after the one-year mark (e.g., at 366 days). This classifies the profit as a long-term capital gain, subject to the lower tax rate.

The European Context: A Completely Different Game

If you live outside the US, the Greenblatt trick might be completely useless. You must understand your local tax laws:

  • No Capital Gains Tax: Countries like the Netherlands, Belgium, or Switzerland historically do not tax capital gains on stocks for private investors (they may use wealth taxes or transaction taxes instead). If you live here, turnover doesn't matter for taxes; you only need to worry about broker fees.
  • Tax-Advantaged Accounts: In the UK, using a Stocks and Shares ISA means your capital gains are completely tax-free. Always try to run a high-turnover strategy like the Magic Formula inside a tax-sheltered account if your country provides one.

General Tax-Smart Tips for the Magic Formula

Regardless of where you live, follow these best practices:

  • Use Sheltered Accounts: Whether it's a Roth IRA (US), an ISA (UK), or a TFSA (Canada), put your Magic Formula portfolio in an account that shields you from yearly capital gains taxes.
  • Factor in Dividend Taxes: The Magic Formula doesn't screen for dividends, but some stocks will pay them. Be aware of dividend withholding taxes, especially if you are buying foreign stocks.
  • Don't Let Taxes Ruin the Math: Never hold onto a fundamentally deteriorating stock just to avoid paying taxes. The rules of the formula come first; tax optimisation comes second.

Conclusion

The true return of the Magic Formula is not what the backtest says — it is what ends up in your bank account after fees and taxes. By executing the buying and selling exactly around the 360/366-day marks (where applicable) and utilising tax-advantaged accounts, you can legally keep significantly more of your wealth.

Investing from Europe? Read our dedicated guide to applying the Magic Formula in European markets. And for the full implementation process, see our step-by-step portfolio construction guide.