9 Rebalancing and Tax-loss Harvesting

So now you have a portfolio, or you are in the process of constructing one. You will now want to know how to monitor your assets and make sure your portfolio is functioning effectively. How do you do that? When it comes to portfolio maintenance, the two biggest pillars are rebalancing and tax loss harvesting (TLH). Rebalancing is the process of moving a portfolio’s asset classes back to their target allocation amounts if they have been changed by market movements. Let’s recall Ava’s portfolio.

Ava’s portfolio

• Broad market U.S. Stock (50%)
• Bond funds (20%)
• Real Estate Investment Trusts (15%)
• Gold (15%)

Now, what should happen if there was a particularly good year for bonds and real estate, an average year for gold, and a negative year for the stock? These result in the following new asset percentages.

Ava’s portfolio after a year

• Broad market U.S. Stock (35%) -15%
• Bond funds (30%) +10%
• Real Estate Investment Trusts (20%) +5%
• Gold (15%)

In this situation, Ava would want to rebalance back to her target weights. To do this, she would sell the assets that have appreciated beyond their allocation target, in this case, bonds and real estate, and buy the asset(s) that have fallen below this threshold. The following numbers illustrate this in action if Ava’s portfolio had a starting principal balance of $10,000. After year one, her portfolio returned 10%, giving her $11,000 at year’s end.

Ava’s portfolio in dollar terms at the start ($10,000 total value)

• Broad market U.S. Stock (50%) or $5,000
• Bond funds (20%) or $2,000
• Real Estate Investment Trusts (15%) or $1,500
• Gold (15%) or $1,500

Ava’s portfolio after the first year ($11,000 total value)

• Broad market U.S. Stock (35%) or $3,850
• Bond funds (30%) +10% or $3,300
• Real Estate Investment Trusts (20%) or $2,200
• Gold (15%) or $1650

The differences in dollar terms are as follows: Broad Market Stock (-$1,150), Bond funds (+$1,300), Real Estate Investment Trusts (+$700), and Gold (+$150). Assuming that the principal value is $11,000, and the allocations are targeted as they were when the portfolio was created, these are the dollar amounts of each position she should have:

Ava’s portfolio target in dollar terms (end of year one)

• Broad market U.S. Stock (50%) or $5,500
• Bond funds (20%) or $2,200
• Real Estate Investment Trusts (15%) or $1,650
• Gold (15%) or $1,650

Now all that’s left for her to do is buy and sell these assets in order to get them back to their target weights. For example, she should sell approximately $1,100 worth of bonds, lowering that position’s percentage of the portfolio back down to 20% or $2,200. She should also sell $550 worth of real estate, reducing that position down to its target of 15% in the portfolio. From these sales, she will be newly armed with $1,650 worth of cash, and since cash isn’t in her portfolio strategy, she can use it to purchase new assets. She should use it all to buy stock, which will rebalance the stock portion to equal 50% of the portfolio, $3,850 + $1,650 = $5,500. Her rebalancing process is now complete. By doing this, Ava has made a few things easier for herself. First, she has automated the portfolio maintenance part of her investing journey and has an easy strategy to keep her assets close to what is dictated in her financial plan. It is general wisdom that rebalancing should occur either once or twice a year, on memorable dates like the summer and winter solstices or a birthday and anniversary. Secondly, Ava has protected herself from the market in some regards, taking some money off the table in what has done well and adding to what has lagged behind. Because of the long-term uptrend in the prices of almost all assets, she is making sure to capture the returns from all the different sources. And remember our discussion about getting lucky enough to buy at the low point each year? Well, this could help make that easier, if a large selloff were to occur around the time of rebalancing. Rebalancing is the first tool in an investor’s kit, the second being Tax Loss Harvesting or for our purposes, TLH.

TLH might sound a little complex. Isn’t harvesting for farmers? Don’t worry, we will break it down. Taxes are an important consideration for asset owners. As a general rule – if something makes you money, the government will take its fair slice. When you sell an asset at a gain, it incurs what is called capital gains taxes. There are two kinds of capital gains taxes: short-term capital gain (STCG) and long-term capital gains (LTCG). Any assets held for a year or more will be subject to long-term capital gains taxes. Any under that threshold will be subject to short-term capital gains taxes. It is very important to make note of the fact that the short-term capital gains tax rate is significantly higher than the long-term capital gains tax rate. Asset owners are discouraged from quick buying and selling by the tax code, incentivized in this way to be long-term buy and hold investors. There isn’t a way for me to accurately tell you what your short and long-term capital gains taxes will be, as they are marginal and will depend on your level of income. If you make more, you will pay higher capital gains taxes. It’s not all bad, though. Sometimes you can use it to benefit yourself, through the tax loss harvesting strategy.

Tax loss harvesting involves selling an asset that is currently at a loss and replacing it with a similar asset that, for portfolio diversification purposes, will function the same. Materializing this loss will reduce your taxable income and offset any capital gains for that same year. Let’s bring Ava back to illustrate this. If we remember after her first year, the stock portion of her portfolio was down from $5,000 to $3,850 – an unrealized loss of $1,150. We use the term unrealized to mean that she hasn’t yet sold. If we recall from the previous example, Ava purchased more stock to get her back to her target allocation. There is another step Ava can take before doing this, which will make her portfolio even more efficient. Before getting her stock allocation back to 50% of her portfolio, she should sell the entire position first, essentially cashing out any losing position. For taxes, she now must record how much has been lost since her purchase. By doing this, she has realized her capital losses, and now has an amount of $1,150 which can be deducted. In essence, she has provided herself with another $1,150 of money returned and can continue this strategy on her assets, up to an amount of $3,000 per year.

What about the stock in her portfolio though? Now it’s gone and she has a whole load of cash. What can she do? Ava must purchase an asset that will perform similarly to the broad market stock fund she had before. She has a couple of options here too. She could pick a different ETF or fund, she could pick individual companies, she could even choose an international plus U.S. stock fund (whole world fund). There are actually plenty of options and just one rule: she can’t purchase identical security or fund, or she will lose the ability to write off her losses. Ava decides to pick a different ETF, one that has broad market stock exposure but also an ESG component. She then proceeds to put in the $3,850 from her sale, plus the $1,650, in order to get her amount back to the 50% stock allocation. She has rebalanced and tax loss harvested for the year, and now her portfolio is ready for the next.

These two strategies are the minimum necessary for portfolio upkeep. Depending on your situation, more involvement may be helpful but is not required. The average investor is best suited to rebalance and tax loss harvest on specific dates each year, and to automate the process as much as possible. We can never know what the market will do, but we can be flexible and move with it. It is important to always remember the tax implications of any investment that is sold. It will always generate a taxable gain or taxable loss – nothing escapes Uncle Sam. For those with more complex tax situations, more planning may be necessary – consulting with a professional for help is a good idea. If you are just starting your portfolio adventure, this will do just fine.