Portfolio Rebalance via Divesting - Wilson Wealth Management

In How to Rebalance a Portfolio, we reviewed how you can either “divest and immediately reallocate”, or simply “reallocate future acquisitions”, as easy ways to rebalance back to your target asset allocation.

By divesting, you can quickly shift back to your target. By reallocating future investments, it may take substantial time.

However, divesting can generate capital gains taxes payable from selling outperforming assets. Taxes are a substantial drag on growth. The longer you keep wealth in your possession, the better your compound returns. You should try to minimize paying out taxes early on and let the entire money work for you as long as is possible.

Note that if you hold all your investments in tax-deferred accounts, this is not an issue.

For example, you have $100,000, earning 8% annually for 40 years, compounding once annually at year end. If residing in a tax-efficient investment account, it will grow to $2,172,452. If held in a regular account, you must pay tax on the yearly income. At a 35% tax rate, your capital now only grows to $759,678. Quite the incentive to utilize tax-efficient accounts.

Regardless of the potential tax hit, there may be times when it is prudent to consider selling and reallocating.

Non-Diversified Portfolio

Many investors maintain poorly diversified portfolios. As a result, it may make some sense to divest outperforming assets rather than try to simply adjust future investments.

Amongst other things, a well-diversified portfolio is one in which no individual investment has substantial impact on the portfolio as a whole. But many investors tend to have one or two stocks that dominate the overall portfolio.

For example, you and your brother own shares of Apple Inc. (AAPL).

AAPL is one of 20 stocks in your brother’s portfolio and accounts for about 5% of the equity component of his assets. That suggests that the portfolio may be diversified (other factors need to be reviewed before a conclusion can be reached).

You also own 20 stocks, but AAPL is 40% of your holdings. If the AAPL share price increases or decreases by 20%, the impact on your portfolio is significantly more than on his. Your portfolio is not well diversified (regardless of other factors).

This can have a few ramifications.

One Stock May Dominate

If AAPL increases quickly in price versus other holdings, you may find that it has become 50% or more of your portfolio.

This is the “too many eggs in one basket” concern. Where nonsystematic risk factors have substantial influence.

In contrast, an increase in AAPL share price will have less impact on your brother’s portfolio.

And, if the share price falls, your entire portfolio suffers based on one holding.

As to what constitutes “too many eggs”, there are many variables that determine proper diversification.

I would suggest though that no single asset (note that diversified investments such as funds are excluded) should make up more than 20% of one’s portfolio. And, in most cases, the percentage should be much, much less.

Abnormal Returns

Perhaps you own shares in 5 different companies. The benchmark market index returns 20% for the year. 4 of your 5 shares return between 10 and 15%, Yet one company has increased by 200% during the year.

As above, you may find that this one company now dominates your portfolio.

Also, the extreme performance of the one stock may mask the relative underperformance of the others.

But there is another potential issue.

Perhaps there is a reason for the company’s shares to appreciate this much. Maybe they developed an innovative product, discovered a huge reserve of natural resources, etc. The increase, and future potential, may be justified.

Or maybe the company has been over-hyped and is due for a correction in price.

Depending on your analysis and conclusions, you may wish to take some profits in case the stock has become overheated and the share price falls.

There are a variety of ways to trim your holdings in a single company.

You could sell everything and realize a large profit. In our example, 200% over one year before taxes.

Or if you think there is further upside, but are not certain, you could sell a portion of your holdings.

Perhaps you bought 1000 shares at $10 per share. After one year, the share price has climbed 200% to $30. If you sold 334 shares, you would have completely recovered your initial investment. You could hold the remaining 666 shares forever, knowing that they are “free”.

Or, if you are more risk averse, you could sell a higher percentage. By selling 500 shares at $30, you would realize $15,000 before tax. A 50% gross return on your initial investment. You now have less for future appreciation, but a 50% realized gross return and 500 “free” shares remaining is not too bad.

Investment Bubble

A single asset, market, or market segment that increases substantially in price might be prime for an investment bubble.

An investment bubble may be foreshadowed by abnormal returns in an asset or group of assets.

Look at the dot.com investment bubble and its crash in 2000. Your specific investments might have been solid companies, but they would have been caught up in the panic selling. The same is true with U.S. housing prices during the last decade. Many excellent houses sold at discount prices simply because the market as a whole was in difficulty.

As is said, “an ebbing tide, lowers all boats.” True, to a greater or lesser extent, with stocks in market crashes.

Even if you think your own individual investments are solid, to protect your portfolio it might be wise to sell a portion of your holdings in that asset or market segment.

Again, the percentage to sell depends on your analysis and conclusions, as well as your personal risk tolerance.

Summary

At times, it may be worthwhile to rebalance your portfolio by selling individual assets.

The costs of taxes payable might be worth the value you get by having one asset dominate your holdings and the resulting risks that come from having a weakly diversified portfolio.