While you are looking at your investments, it is a good time to evaluate your investment decisions from the past year. Consider how your portfolio has performed relative to a benchmark like the S&P 500 Index. The S&P Large Cap holdings were up more than 25 percent year-to-date. Have your equity investments held up as well? Likewise, if you have purchased gold funds in the last 10 years, the price of gold is down nearly 25 percent in 2013. It may be time to make some changes, depending on where you think the market might go in the next few years.
You can make changes to your portfolio through two basic strategies: rebalancing or redesigning. Redesigning is often more drastic and often associated with life changes, such as retirement and changes to your financial goals, such as a new need for education cost planning.
Rebalancing is when you sell or buy investments in your portfolio to maintain consistent asset allocation percentages. If some of your investments are performing significantly better (or worse) than others, you may need to rebalance to maintain the distribution and risk profile you desire. For example, your Consumer Discretionary holdings likely saw a gain of 35 percent this year, while your Materials sector holdings may have only seen gains around 6.4 percent. You may find that some of your Consumer Discretionary holdings are now more than 10 percent of your portfolio.
One way to rebalance your portfolio is to sell assets that have grown. With the proceeds, you invest in other equity sectors or individual stocks to return the portfolio to your desired ratios. Most investors ask, “Why am I selling some of my stocks that are performing well to buy more stocks that are performing not so well?” It does seem a little backward, but remember that diversification is necessary. A long-term investment approach does not mean “set it and forget it.” The stock market is cyclical; therefore, some sectors outperform others during different economic cycles. While Consumer Discretionary and Healthcare stocks outperformed Energy and Technology stocks this year, it is very likely that things may be different next year.
The difficult portion of this method is determining the tax liabilities associated with selling assets that have appreciated in value, and then reinvesting the proceeds. Transaction fees and commissions need to be accounted for when rebalancing. If you are concerned about the tax consequences of selling a portion of your investment winners, you may want to wait until Jan. 1 to sell. Thus, you defer your capital gains until 2014. You then have an entire year to make adjustments to offset any realized gains.
Another rebalancing option is to dollar cost average funds into your underweight positions. This can help ensure that your portfolio continues to grow, and your sector allocation is returned to the desired levels. Next week, I’ll take a closer look at when and how to redesign your portfolio.