NEW YORK (MainStreet) – Don't feel too good about a retirement portfolio stocked with winners and lacking losers. That imbalance is more dangerous than you think.
Rebalancing a portfolio is an important part of any investment strategy, but it's vital to your retirement. Sure, you can set and forget your asset allocation, but rising markets can make your financial future overly dependent on one investment. Meanwhile, falling markets can chip away at underperforming investments and leave your overall portfolio depleted and vulnerable.
This basically requires you to sell off some of those high-flying winners and buy up some more of the losers while they're at their lowest. If you're doing this in the confines of a tax-free retirement account, you don't have to worry about the tax implications of those moves, but you do have to consider maintaining at the level of risk you're willing to accept in a well-diversified portfolio that's built for the long haul. Steve Wallman, founder and chief executive of Folio Investing, notes that you want your portfolio to be in a position where it can grow over time and where you can take a little risk and allow yourself time to recover if there's more volatility than you expected.
“You're able to go for higher levels of risk to get higher levels of return, but you should only do that if you're well diversified, because otherwise you might be in a position where you really bet wrong on a couple handfuls of stocks,” Wallman says. “If that's the case, you may not be able to recover at all, especially if they go under.”
If you're looking for an example of how imbalanced portfolios can go wrong, just look back to 2001 and the Enron collapse. Wallman notes that whole retirement plans were wiped out not strictly because investors bought shares of Enron, but because they made those shares far too large a portion of their retirement plan instead of diversifying.
“While long-term investors may not be concerned about the short-term impact of global events or changes in monetary policy, it’s still important for them to be aware of how those events could impact their long-term goals,” says Joe Correnti, senior vice president of brokerage product at Scottrade. “Ups and downs in the market can alter investors’ asset allocations and, if left unchecked, could result in their long-term plans getting off track.”
So when's the right time to rebalance? Correnti notes that some investors choose to rebalance their portfolios on the same day each year, while others rebalance as their personal financial situation changes (new job, retirement, additions to the family, etc.). Wallman, however, says rebalancing should depend less on the calendar and fluctuations at home than on the health of the portfolio itself.
“It depends on how diversified and well-balanced the portfolio was to begin with,” Wallman says. “We think people should start with 30 or 40 securities, a well-diversified mutual fund or something with a half-dozen or dozen well-diversified mutual funds or ETFs to begin with. If that's what we're talking about, then movements of plus or minus 10% off of their benchmarks are probably good indicators that they should push the button and rebalance.”
Even that approach to rebalancing should take a few variable into consideration. For one, rebalancing your investments doesn't always come free. If your brokerage charges a commission for such transactions, then annual rebalancing can get costly.
“If you're in a platform where you're being charged a commission of $8 or $9 per trade and you've done a really nice job of creating a diversified portfolio of 20, 30 or 40 securities, if you were to rebalance those every quarter, you're talking about over $250 in commissions for just one rebalance,” Wallman says. “If you do that every quarter, that's $1,000 a year just to rebalance.”
You'll also have to keep in mind that a well-balanced portfolio isn't always stocked with tax-free offerings. You may want to keep investments with large amounts of ordinary income within tax-deferred accounts, such as an IRA. That reduces the tax bite on your portfolio and allows for additional long-term compound growth and higher total returns. But there is an upside to taxable investments, according to Thomas Walsh, an investment analyst with Palisades Hudson Financial Group in Atlanta.
“Without incorporating a taxable brokerage account to hold some of your investments, you lose the ability to tax-loss sell,” Walsh says. “Tax-loss selling involves realizing losses in a down year to offset realized gains in an up year, all while maintaining your target asset allocation. When you sell an investment to capture a loss, you reinvest the proceeds in an investment with similar characteristics, thus your portfolio retains the same market exposure as before the tax-loss sale.”
As long as you don't trigger a “wash sale” by buying back, within 30 days, an investment the IRS deems substantially identical to the investment sold at a loss, you should be able to reap tax losses without much issue. Correnti points out, however, that long-term investments (those held for more than a year) and short-term investments (those held for a year or less) are taxed at different rates. Some short-term gains can be taxed more than twice as high as long-term gains, so addressing the imbalance between short-term and long-term investments can be crucial to avoiding a huge tax hit.
"Even if you're rebalancing a position that's 25% of your portfolio back down to 10%, it might have been bought over the course of a year or two years and might have multiple tax losses in it,” Wallman says. “You don't want to be in a position where because of concern about incurring a tax, you end up in a concentrated portfolio that gives you a way higher amount of risk than you're able to take.”
Those in high-income tax brackets have the most to gain from from tax-loss harvesting. If there aren't any capital gains to offset with the losses, the IRS allows the taxpayer to deduct up to $3,000 of capital losses. For those in the top 39.6% tax bracket, this can translate to roughly $1,200 in tax savings without drastically investment portfolio. That said, an investor shouldn't compromise investment objectives or asset allocation to save some on taxes.
“Of course, there are many other factors to consider during your portfolio rebalance besides account types and taxes,” Walsh says. “Considering these alongside items such as redemption fees, trading costs and investment minimums, to name a few, all fit together to paint your unique portfolio’s big picture.”
— Written by Jason Notte in Portland, Ore.
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