Why You Must Take Capital Gains to Rebalance Your Portfolio (EP.144)

0:28We all need to make smart decisions with our money. low, sell high is not just a catchy phrase, but a foundational strategy for wealth accumulation. Yet, when it comes to a disciplined approach for portfolio rebalancing, investors often find themselves in a conundrum, particularly with the necessity of realizing capital gains. Rebalancing, which is the process of realigning the weightings of a portfolio's assets, is critical for maintaining desired risk levels and investment outcomes. However, it often involves selling assets that have appreciated in value, thereby incurring capital gains taxes, which is a scenario many investors are loathe to face.

1:09But it's also a pill that investors need to start preparing to swallow. In this episode, I'm going to explain exactly what I'm seeing that makes me say that, and then I'll be exploring the trade-offs between taking capital gains and rebalancing your portfolio, which again is considered an essential part of portfolio management. And finally, I'll conclude with some strategies that help minimize the tax impact of regular rebalancing. Now, to understand why rebalancing is going to result in capital gains for a lot of investors in the relatively near term, we first must understand another portfolio management strategy, which is tax loss harvesting.

1:49Tax loss harvesting is a proactive measure to reduce overall tax liability and improve the after-tax return of a portfolio by selling securities at a loss to offset a current or future capital gains tax liability. The process involves realizing a loss in one security and replacing the position with a security that has similar if not nearly identical exposure. When done effectively, tax loss harvesting doesn't really change anything about the makeup of your portfolio, but you walk away from the transactions with capital losses that you can then use to neutralize the taxes owed on the gains from other investments.

2:27Now, this strategy is relevant to the overall conversation of the episode because the bear markets in 2020 and 2022 presented investors with a ton of tax loss harvesting opportunities. And if you were prudently harvesting those losses, that means a good amount of the proceeds from those sales got reinvested at low points in the market. Fast forward to the present, the stock market and particularly the U.S. stock market has delivered very high returns since those bear market lows. And those positions that you took as a result of tax-loss harvesting trades now have large capital gains liabilities, which brings us back to rebalancing.

3:09And here is what I'm seeing in my everyday job. So as of this recording, Plancourt manages a little bit over$6.5 billion for roughly 1 ,600 clients across the United States. and every single day our portfolio management team looks at every portfolio for rebalancing and tax loss harvesting opportunities. And what I'm seeing when I review our team's reports is that equity weightings are generally above their target asset allocation with the US portion of the portfolio being the most overweight. And not only do I see this across our client base, but I'm also seeing it in the investment statements of prospective clients, as well as a couple of the foundations where I am either a board member or an investment committee member.

3:51And so what that suggests to me is that anyone listening with a long-term strategic asset allocation is probably in a similar position and ought to consider rebalancing their portfolio. Now, why is this so important? You see, decades of financial research has overwhelmingly shown that asset allocation is the primary driver of differences in returns. And for all the amount of time that investors, including myself, spend studying and debating investment strategies, no single choice will have a greater impact on your returns than the mix of stocks and bonds that you hold in your portfolio. Now, ideally, your asset allocation is informed by a thoughtfully created financial plan, one that assumes you are regularly rebalancing.

4:39And that's because in many ways, rebalancing is a risk management tool. Over time, regardless of what part of history you look at, some investments outperform others, and the portfolio becomes overweight in certain sectors or asset classes, inadvertently increasing the exposure to specific risks contrary to the investor's original risk tolerance. Rebalancing helps in mitigating this risk drift by ensuring that the portfolio remains aligned with the investor's financial goals and risk appetite. The other potential benefit to rebalancing, although it is very time period dependent, is that it can enhance returns.

5:18By selling high and buying low, rebalancing forces investors to take profits on high performers and invest in underperformers, potentially buying undervalued assets that may appreciate in the future. And although this strategy does not guarantee higher returns, it still fosters the discipline necessary for long-term investment success. Now, as I was saying earlier, for the vast majority of U.S. investors, right now what that means is probably selling from U.S. equities where the gains are the biggest and the taxable consequences are the biggest, and then buying international equities and or fixed income following a period where those asset classes have dramatically underperformed U.S.

6:02markets. And if you have a significant portion of taxable investments, again, that's going to mean paying capital gains taxes. The necessity to realize capital gains and thereby incur taxes can be seen as a stumbling block. And just to make sure everybody's following along here, taxes on capital gains are triggered when an investment is sold for more than its purchase price. And these can significantly eat into an investor's returns. But for long-term investments held more than a year, the U.S. federal tax rates on capital gains are a bit lower than in the short term. If you hold it for less than a year, you're going to pay ordinary income tax rates, whereas the long-term rate can range between 0 % and 20%, depending on your income, with additional state taxes possibly applicable.

6:49Now, despite the tax implications, the avoidance of realizing capital gains can lead to a misaligned portfolio, exposing you to unintended risks and possibly long-term underperformance. Therefore, I believe investors should view tax consequences as just one factor in the broader context of maintaining a balanced and strategically aligned portfolio. So while the realization of capital gains might be a necessary part of portfolio management, there are some strategies that investors can employ to minimize their tax impact. For starters, you can use tax-advantaged accounts. I mean, whenever possible, rebalancing within these tax-advantaged accounts, such as an IRA or a 401k, can avoid immediate tax implications, as transactions within these accounts don't trigger capital gains.

7:39The challenge is that eventually you can get a less-than-optimal asset location, which, by the way, is different than asset allocation. Asset location is all about placing investments in accounts that maximize their after-tax return. For example, you wouldn't want your Roth IRA to hold only bonds because that's the account you want the most growth from, and bonds are typically pretty stable and offer very minimal growth. Similarly, an over-reliance on tax-advantaged accounts for rebalancing can lead to them being all U.S. or all international, which maybe in the grand scheme of things isn't a huge deal, but it can become a little disruptive if and when you eventually need the money from these tax-advantaged accounts.

8:24A second strategy is harvesting tax losses. Yes, the very strategy that likely has investors with a whole bunch of gains right now, particularly in U.S. stocks, is the same strategy that can be used to mitigate the tax impact of rebalancing. If you haven't used the losses taken in 2020 and or 2022. And I keep using those years just because they were bear markets, but obviously an investor could have harvested losses in other recent years. But you can take those losses and apply them to this year's gains as well as gains in the future. Now, some people will wait until the end of the year to do tax loss harvesting, but really you should be looking for opportunities all throughout the year because mid-year losses have a nice little habit of disappearing by year end.

9:10A third strategy is to look at holding periods. Holding investments for more than a year ensures that any gains are taxed at the lower long-term capital gains tax rate rather than the higher short-term rates that are applicable to investments held for less than a year. So all else equal, when you're doing rebalancing, you ought to focus on positions that are subject to those long-term capital gains, if at all possible. Another strategy that we will sometimes employ will be gifting appreciated securities, because instead of selling those appreciated assets, investors can gift them to qualified charities and even to family members who are in lower tax brackets.

9:48And this strategy, too, can help avoid capital gains taxes while fulfilling philanthropic goals or aiding in wealth transfer. The next strategy I think is becoming more and more popular, which is harvesting losses inside separately managed accounts or SMAs. More and more people are referring to this as direct indexing, and I extensively cover this topic in episode 95 named What is Direct Indexing? But to quickly summarize, using an SMA is sort of like having a mutual fund or ETF, but just for one person, just for yourself. And the benefit from a tax perspective is that the fund manager can tax lost harvest at the individual security level.

10:31So instead of buying an S &P 500 index fund that you can only tax lost harvest when the entire S &P 500 is down, an SMA tracking the S &P 500 can harvest losses of the holdings within the index whether the entire market is up or down. So I think that's a really popular way to make sure you have ongoing losses to use for current year or future year rebalancing needs. Now, my last one, I'm going to say very lightly and really just to a specific demographic, and that is change your allocation. And when I say I'm saying this to a specific demographic, I think it's really investors who are in their 70s or older.

11:14In general, investors over the age of 70 who expect to pass on wealth at death often have too conservative of an asset allocation. In reality, a portion of this demographic's portfolio is really for the next generation who has a longer time horizon, and as such, the asset allocation should reflect that. So while I'm very, very, very hesitant to change an asset allocation solely to avoid taxes, My tolerance for the idea increases as investors age. Plus, according to current tax law, cost basis will reset at death, so the incentive to avoid taxes later in life is much higher. But one caveat to even this one exception about changing allocations that I'm making.

12:03It's important to stress test your financial plan before making such an adjustment. But most people who are comfortably financially independent and over the age of 70 probably have the ability to take on more risk if they really want to. So while I'm opening the door to a certain demographic for conversations about changing allocations, my overwhelming feeling is that taxes should not negate asset allocation, which again is the single largest driver of long-term returns. because if you start to ignore asset allocation, then you're ignoring your financial plan. And just like I would tell you to stay the course during a market downturn because it's been accounted for in your financial plan, I truly believe that you should stay the course and rebalance because that too is in your financial plan.

12:58I'm not trying to say taxes aren't important. Taxes are a very important consideration in investment management, but they really should just be one of many factors dictating your investment decisions. As always, thanks for listening. And until next time to long-term investing.

13:34All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.