By; Rodney Hunter
You’re investing your money so it can grow, right? Well, think of capital gains as a “medal” for your investing. Many investors turn down that medal because they overestimate the tax liability and the benefit of avoiding that tax liability. And since long-term investors usually realize capital gains when it’s time to rebalance their portfolios, they may also significantly underestimate the risk of not rebalancing.
Don’t sabotage your strategy
If you choose not to act on your portfolio because you don’t want to pay taxes, you risk sabotaging a sound—and consistent—investment strategy. I see 2 dangers here:
Taking on too much risk. Let’s assume a hypothetical investor had a 60% stock, 40% taxable bond portfolio at the beginning of 2005. The 2006 market returns had him walking on air, and he didn’t want to pay taxes on capital gains after rebalancing. Then, life got busy and the global financial crisis hit. He couldn’t bring himself to look at the damage, but he didn’t sell out either. That doesn’t necessarily mean mistakes weren’t made. Because he didn’t rebalance after 2006, his portfolio edged closer to 70% stocks just before the bear market calamity. His portfolio would have experienced a cumulative loss of 31.18% between 12/31/2007 and 03/31/2009, which is 4.59 percentage points higher than a 60/40 split.2 But the bad news doesn’t stop there. Without rebalancing during the bear market, his portfolio likely fell to below 50% stocks by March 2009. Thus, his portfolio can’t recover as quickly as stocks began to rebound. According to New Aged Wealth Asset Management research that mistake would have cost the investor several percentage points of return. Developing a concentrated portfolio. If you don’t rebalance your portfolio, it could become more skewed toward individual high-performing investments. In this case, your portfolio is more subject to increases in volatility and possible underperformance if that investment falls out of favor. We recently published a great research paper on concentrated equity positions that I recommend to all my clients in this scenario to help them come up with an action plan.
Change of mindset
I also hear justifications for ignoring rebalancing from investors. Some consider rebalancing a nuisance. Others want to stay with their stock allocation because they think the stock market will continue rising. But we believe rebalancing is part of a sound investment strategy. I often remind clients that “staying the course” (another tenet of our investment philosophy) isn’t only a passive phrase used to prevent you from selling out when things look ugly..
New Aged Wealth Asset Management has researched a variety of rebalancing strategies. While there may not be a clear optimal strategy, we believe having a strategy is better than not having one. Most rebalancing strategies rely on one trigger that’s based either on timing or a specific shift in asset allocation.
That’s why we recommend rebalancing—even if it means paying taxes on capital gains. You’ve worked hard to invest your money and see it grow. Claim your prize!
In a future blog post, I’ll address some of the more complex investment management techniques that you can use to help reduce your tax liabilities.
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