The Error-Proof Portfolio: Go Ahead, Sell Some of Your Stocks

Amid the ongoing gridlock in Washington, many investors are on pins and needles about what all of this will mean for the markets and, in turn, portfolios. Even if the current crisis is averted, the dysfunction in Washington appears likely to continue, and that's not good for markets. After I gave a retirement-centric presentation for a group of individual investors last week, one person after another came up and asked me if it's time to sell stocks. 

And believe it or not, my answer was "Yes, it may well be." 

Regular readers know that I'm not a fan of investing based on the news flow. News about the macroeconomic picture tends to be rapidly priced into securities' valuations, so positioning your investments to benefit from or protect against a specific economic event is usually a sucker's game. When the headlines are especially bad, investors get a little short-term psychological relief after retreating from stocks, only to be left with a new nagging problem, especially if equities begin to recover: Is it time to get back in?

That said, I'd argue that many investors should, in fact, be trimming their stocks right now--not for short-term tactical reasons, but because, in many instances, long-term strategic considerations call for it. 

Out of Balance?
Assume that an investor had a 50% bond/50% stock portfolio five years ago, when the financial crisis was in full gear--$10,000 apiece in a total stock market index fund and a total bond market index tracker. Stocks went on to drop further still in early 2009 before rebounding subsequently, and bonds have performed respectably. If there were no further changes to the portfolio, our (onetime) balanced investor would now be sitting on almost $35,000. Nearly $22,000 of that portfolio (62%) would be in equities, and the remainder in bonds. 

And that's assuming that the investor had not been adding to his equity holdings on the way up. Many investors have been doing just that, however, as evidenced by the positive equity-fund flows we've been observing during the past few months. My example also assumed a plain-vanilla broad market equity portfolio. If an investor had exposure to small- and mid-cap stocks, which have been on fire, appreciation in those holdings would have skewed the portfolio's asset allocation even more heavily toward stocks. 

Long story short: Appreciation in existing holdings, plus the fact that many investors have been adding to their equity holdings during the past year, makes it highly likely that portfolios are heavy on stocks relative to their original targets. 

Of course, it might be tempting to revisit those asset-allocation targets to help justify letting your stocks ride, particularly given that stocks have performed so well during the past several years as well as the fact that bond prospects don't appear especially bright. But the point of strategic asset allocation--setting out targets for your allocations and generally sticking with them except to make your portfolio more conservative over time--isn't that you override your whole plan because you have a hunch that one asset class will perform better than another. 

I discussed the case for rebalancing back into bonds in this article, and the experts I interviewed agreed that investors shouldn't second-guess their strategic asset-allocation plans, even though the headlines about bonds might seem scary.

Another argument for lightening up on stocks via a rebalancing program? Equity valuations, while not crazy, aren't exactly low, either. The typical stock in Morningstar analysts' coverage universe was trading a touch above its fair value as of Oct. 11, and stocks in specific sectors--notably consumer cyclical (restaurants and retailers, among others) and technology--look notably expensive to our analyst team. 

Getting It Done
Of course, it's possible rebalancing doesn't make sense for you at this time; it depends on the composition of your portfolio. Thus, the first step in assessing whether it's time to rebalance is to take an X-Ray view of your portfolio's allocations and compare them with your targets. (If you don't have targets, this article provides some guidelines.) I usually recommend that investors rebalance when their exposures to the major asset classes are 5 or 10 percentage points above or below targets--5 if you want to be hands-on and 10 if you'd like to be laissez-faire.

If you determine you need to lighten up on stocks, it's smart to take a surgical approach rather than reducing all of your holdings proportionately. That way you can leave in place holdings that may have room to run while trimming those that are more likely to be overvalued. The median small- and mid-cap stock in Morningstar's coverage universe currently has a higher price/fair value ratio (1.06) than the median large-cap stock's price/fair value (0.99). Likewise (and not surprisingly), the median stock in the value row of the Morningstar Style Box has a price/fair value of 0.98, making it more attractively valued than the median stock in the blend (1.02) and growth (1.08) bands. The large-value square of the style box currently has the lowest median price/fair value of any style-box square (0.93). 

Selling what's appreciated can, of course, trigger capital gains, so it's smart to try to restore your portfolio's allocations by focusing on your tax-sheltered accounts, where you won't incur taxes when you reposition. Only if you can't move the needle with your IRAs and 401(k)s should you consider selling appreciated holdings from your taxable account, and even then you may be able to lessen the tax burden by selling losing positions, as discussed in this article.

For those who are over age 70 1/2, it's a smart strategy to use required minimum distributions to help aid in rebalancing, withdrawing from your portfolio's most highly appreciated positions. This article discusses how to make the most out of your RMDs from a portfolio-management standpoint.

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