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Investing Specialists

The One Portfolio Move to Make Before Year-End

This simple maneuver can de-risk your portfolio, create in-retirement cash flows, improve your tax position, and more.

Are you looking for tips on improving your portfolio? As part of Morningstar.com's Portfolio Makeover Week in December, director of personal finance Christine Benz will be making over five real-life portfolios to show how investors of all stripes may streamline and upgrade their holdings. To be considered for a makeover, submit a request to portfoliomakeover@morningstar.com. Include a general description of your situation, including portfolio size, as well as your goals for the makeover. We will alert you if we decide to feature your portfolio on the site and will remove any personally identifying information in any published material.

Right about this time of year, the lists of financial tasks you're supposed to complete between now and year-end start to pile up. And unfortunately, all those financial to-dos come at a time of year when you're probably busy with the rest of your life--the holidays bid for your attention, of course, and you may also be contending with year-end work deadlines.

But there's one task that you really shouldn't put off, not just because it can help improve the way your portfolio behaves but also because it can aid you in achieving other valuable financial goals. I'm talking about rebalancing, the practice of scaling back appreciated positions and restoring the portfolio to the investor's target asset allocation.

Some investors assume that rebalancing enhances returns, but that's a bit of a misconception, at least when it comes to rebalancing between stocks and bonds. After all, a portfolio that isn't rebalanced will usually feature ever-higher equity weightings, and stocks tend to outperform bonds over a full market cycle. Given that, it's probably not surprising that rebalancing doesn't usually boost returns and may in fact cut into them.

Instead, the main rationale for rebalancing is that it can help reduce a portfolio's volatility level. (This blog post from Michael Kitces includes a graphic depicting the performance of a rebalanced portfolio relative to a buy-and-hold portfolio; the two end up with similar returns, but the rebalanced portfolio is much less volatile.) In a nutshell, the practice of scaling back appreciated securities pre-emptively can spare you the pain of watching the market knock them down for you.

But the more I think about rebalancing, the more it's apparent that it's the Swiss army knife of portfolio activities. It can help you reduce risk in your portfolio, which is particularly important given stocks' extended winning streak and the prospect that recent market volatility could continue or even worsen. But rebalancing can help meet other goals, too--including addressing holding-specific issues, creating in-retirement cash flows, meeting required minimum distributions, making charitable contributions, and even improving the tax positions for some investors. From the standpoint of multitasking, investing some of your valuable year-end time in rebalancing looks like time well spent.

Here are the key financial jobs that rebalancing can help you achieve. 

Reducing Risk 
The baseline case for rebalancing is to reduce risk in your portfolio while bringing its asset allocation back into line with your targets. And given that the stock market has ascended for seven-plus years, it's a good bet that many hands-off investors have more riding on stocks than they intended to. For example, an investor with 60% of her portfolio in a total market index fund and 40% in a Barclays Aggregate Bond index fund at the beginning of 2009, when stocks started to rally, would now have 78% of her portfolio in stocks and just 22% in bonds. Meanwhile, the investor is also seven years older and closer to retirement; a more conservative, rather than a more aggressive, asset allocation is probably in order. Finally, equity valuations aren't what they were before. Shiller P/E, a gauge of market valuation that takes into account the cyclicality of corporate earnings, was 15 at the outset of stocks' current rally; today’s it's 25. Lofty equity valuations are a key reason why market experts like Jack Bogle have suggested that investors employ muted return expectations for stocks in their portfolios. 

Under a traditional rebalancing regimen, an investor would scale back on appreciated equity holdings following a market run-up and move the proceeds into bonds. Of course, bonds don't compel right now, either; I already mentioned that yields are skimpy. But if an investor's goal is to reduce risk in the portfolio, high-quality bonds should continue to serve their role as shock absorber, holding their ground or perhaps even gaining a bit in an equity-market sell-off. 

Facilitating Opportunistic Strategies
I've just said that standard rebalancing between stocks and bonds isn't necessarily a returns enhancer. But opportunistic investors may in fact be able to squeeze a return advantage out of rebalancing on an intra-asset class basis. For example, the investor may hew to a baseline stock/bond target while also maintaining targets for small versus large-cap stocks, international versus U.S. stocks, and developed versus emerging-markets equities. The latter, intra-asset-class rebalancing can be additive to returns, as discussed in this article

Addressing Portfolio Trouble Spots
While risk reduction is the key motivating force behind rebalancing, investors can also address trouble spots or upgrade the quality of their portfolios at the same time. For example, let's say that an investor has determined he should cut back on equities because his portfolio is too stock-heavy given his asset allocation. He doesn't need to cut back his equity holdings across the board, but instead can focus his trimming on portfolio problem spots--individual positions that appear to be the most overvalued, are taking up too large a share of the portfolio, or simply don't sync up with his investment philosophy, for example. If his portfolio is listing too heavily toward stocks in part because of his heavy weighting in employer stock within his 401(k) plan, for example, he could see if he could move the needle on his total asset allocation by cutting back that holding. Or perhaps he has begun focusing his portfolio on low-cost index products but he still holds a few pricey actively managed funds; pruning those expensive stragglers could help get his asset allocation in the right ballpark while also bringing his portfolio in line with his philosophy.

Meeting In-Retirement Cash Flows
Despite the recent uptick in bond yields, that's thin gruel for income-starved retirees. High-quality intermediate-term portfolios are currently yielding well less than 3%; the yields you earn on high-quality shorter-term bonds are hardly any better than what you'd earn by parking your money in the bank. That has sent many retirees scrambling out on the risk spectrum in search of higher payouts--into junk and emerging-markets bonds as well as high-yielding stocks. 

Despite the challenging yield environment, one key source of in-retirement cash flows--though not strictly income--is hiding in plain sight: selling appreciated securities. While traditional rebalancing involves redeploying the proceeds from appreciated positions into parts of your portfolio that haven't performed as well, you can also use your rebalancing proceeds to provide needed cash for the year ahead. Retirees can rely exclusively on rebalancing to meet their cash-flow needs (what I call a "strict constructionist" total return approach), or they can use their portfolios' organically occurring income distributions, along with rebalancing proceeds, to meet their cash flows. Of course, there may be years in which neither stocks or bonds perform particularly well and aren't ripe for rebalancing; that's the key reason that all of my model in-retirement portfolios include a cash component so that the retiree doesn't have to sell depressed holdings to meet living expenses. This article discusses the pros and cons of various strategies for shaking cash flows out of a portfolio.

Raising Funds for RMDs
In a related vein, retirees who are post-age 70 1/2 can and should use rebalancing to help meet their required minimum distributions from their tax-sheltered accounts like IRAs. Those distributions, in turn, can be used to fund living expenses, as discussed above. One advantage of rebalancing within tax-sheltered accounts like your IRA is that your selling won't trigger any unnecessary tax bills. If you're rebalancing your retirement accounts to meet RMDs, for example, you'll owe taxes on any money you withdraw, but no more than you otherwise would. And if you’re not yet retired and rebalancing within your tax-sheltered accounts--that is, moving money from appreciated positions back into depressed ones within the same account--you won't owe any taxes at all to rebalance. By contrast, rebalancing within your taxable accounts should be a last resort because selling appreciated positions is apt to trigger a tax bill. 

Making Charitable Contributions
Charitably minded investors can also rebalance by steering appreciated positions to charity. Retirees who are age 70 1/2 or older can take advantage of qualified charitable distributions to send their required minimum distributions, up to $100,000 directly to the charity (or charities) of their choice. The virtue of that strategy versus taking the money out, paying taxes on it, and writing a tax-deductible check to the charity is that the QCD doesn't affect adjusted gross income; keeping AGI down is the name of the game when determining a taxpayer’s eligibility for deductions and credits. 

And investors of any age can rebalance their taxable accounts and steer a highly appreciated position directly to the charity of their choice. That strategy not only reduces risk in the portfolio by scaling back highly appreciated (and potentially overvalued) holdings, but it also helps remove the tax burden that comes along with that appreciated asset. This article discusses these and other charitable strategies. 

Saving on Taxes
Another way that investors can use rebalancing to improve their tax positions is to engage in tax-loss selling. It's a little counterintuitive to scale back equity holdings because they've appreciated in aggregate while also harvesting tax losses, but it's possible. For example, let's say an investor's overall equity position has appreciated beyond her targets but her holdings in an energy-specific fund have dropped. In such an instance, she could sell the energy fund to reduce her overall equity exposure while also booking a tax loss. Tax-loss selling will generally be advisable only for investors' taxable accounts; it's usually not a great idea for IRA holdings, as discussed here