In 2013, the benchmark Standard & Poor’s 500
Index returned more than 32%, and the average domestic stock fund was up more
than 31%, according to Morningstar. Major domestic stock market indexes are at
or near record levels, as of this writing. Since the nadir of the financial
crisis in early 2009, stocks have enjoyed a powerful five-year run.
Is it time to
move out of stocks, or at least trim your holdings? Most commentators advise against
trying to time the market. There’s no way of knowing if we’re at the top of the
market, as we were in 2000 and 2007, or if we’re just beginning an 18-year bull
run like the one we enjoyed from 1982 to the 2000 peak.
Rebalancing act
Market timing may not be recommended, but many
financial advisers favor the concept of rebalancing your portfolio. Here, you
determine an asset allocation to suit your investment goals and your risk
tolerance. If your actual allocation departs from the plan, you’ll act to get
your investment mix back on the chosen path.
Example 1: Megan Harris has a basic
asset allocation of 65% stocks and 35% bonds. After a few years of a bull
market, Megan’s $400,000 portfolio is $300,000 in stocks (75%) and $100,000
(25%) in bonds. To rebalance, Megan would sell $40,000 of stocks and buy $40,000
of bonds. This would bring her to $260,000 in stocks (65%) and $140,000 in
bonds (35%).
Note
that Megan will still have a substantial amount invested in stocks, so she will
continue to profit if stocks perform well. At the same time, she will have less
exposure to a possible stock market reversal.
The
Megan Harris example is extremely simplified. Today, many financial advisers
advocate a portfolio that’s diversified among multiple asset classes. Megan
might hold international and domestic equities, large company and small company
stocks, high grade and lower quality bonds, real estate securities, commodities
and so on. Each asset class will have an allocation, and periodic rebalancing
can keep the mix on track.
Tax tactics
One advantage of continual rebalancing is that it
encourages investors to sell after assets have appreciated and buy other assets
that are currently out of favor. Long term, that can be a formula for
successful investing. It’s also a formula for realizing taxable gains. Some
astute planning can reduce the tax bill, though.
One
approach is to rebalance by executing your asset sales in a tax-favored
retirement plan such as a 401(k) or an IRA. Then, any gains on the sale won’t
be taxed right away. By building up a substantial amount in such an account and
holding a blend of asset classes in there, you’ll increase your ability to
rebalance without triggering taxes.
Another
tax reduction method is to sell assets from a large holding within your
portfolio, acquired at different times. Specify the shares you’d like to sell,
choosing those with the least tax impact.
Example 2: As in our previous example,
Megan Harris wants to rebalance her portfolio by selling $40,000 of stocks. She
sells $15,000 of stock funds held inside her 401(k), avoiding a current tax
bill, but Megan would like to sell another $25,000 of stocks in her taxable
account.
Megan
holds a large position in mutual fund ABC, which she has amassed over several
years. She wants to reduce her exposure to this fund, so she sells $25,000 worth
of fund ABC in her taxable account. When instructing her broker to make this
sale, Megan specifies which shares to sell, choosing those that (a) have declined since her purchase or (b) have relatively small paper profits.
Among the gainers, Megan focuses on the shares that have been held more than
one year and, thus, qualify for the favorable tax rate on long-term capital
gains.
Yet another way to reduce the tax on
rebalancing gains is to build up a bank of capital losses by periodically selling
assets that lose value after you buy them. Such capital losses can offset
taxable capital gains.
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