Maintaining Your Portfolio is a Rebalancing Act

Markets bounce around. That’s just what they do. If they didn’t, they wouldn’t reflect our ever-changing world. As a result, your portfolio bounces around, too, which means your portfolio will eventually look different than it did when you started. Specifically, you’ll be taking the wrong amount of risk. We will want to bring your portfolio back to where it should be through a process we call “rebalancing.”

That sounds simple enough – just sell the stuff that went up, and buy the stuff that went down, right? Actually, we need to pay attention to a lot of potential frictions – a perfect asset allocation doesn’t mean that much if we make a mess of everything else.

The three main frictions we need to pay attention to are:

• Taxes
• Wash Sale Rule
• Trading Costs

Taxes

When we trade in your taxable investment account, we need to think about the effects of capital gains taxes. We need to balance the capital gains taxes we will generate with the benefits of rebalancing your portfolio. We are essentially weighing a direct cost – the capital gains taxes you’ll need to pay – with an uncertain benefit – making sure you’re taking the right amount of risk in your portfolio. This is always a balancing act, and there is no set rule. How we handle these tradeoffs depends on your tax situation and your general disposition toward taxes. There is no right answer – we want to weigh all of the options and come up with the best answer for you.

Wash Sale Rule

The wash sale rule comes into play when we harvest tax losses in your taxable account. These are really useful because they allow us to reduce your capital gains taxes, and in some cases, your ordinary income taxes as well. But we need to be careful here.

Once you harvest a loss you can’t just turn around and buy the security again. The IRS wants to make sure you have actually sold it, and not just moved it from one hand to the other, so no one in your household can buy a “substantially identical” security for the next 30 days. “Substantially identical” is a pretty tight definition – if you sell an S&P 500 index fund, you can’t just buy another S&P 500 index fund, but you can buy another US large-cap index fund like a Russell 1000 index fund – so there are options. If you do break the wash sale rule, the IRS will disallow the loss, meaning you just incurred trading costs for nothing.

We obviously want to avoid this, so we check to make sure any rebalancing we do does not violate the wash sale rule. Since the rule is only in effect for one month, we can decide whether it is better to leave the money in cash or invest it into something with a similar risk profile. Again, there’s no universal right answer, so each case is handled individually to ensure we make the right decision for each client.

Trading Costs

Trading costs potentially affect all accounts. You don’t need to worry about capital gains taxes in your IRA, but you do need to pay attention to trading costs. While trading costs are not particularly large in absolute terms, we want to avoid paying them if at all possible as they are a direct cost to your portfolio. On the other hand, we do need to trade occasionally to make that your portfolio stays in balance. This comes down to one of those “judgment calls” we mentioned earlier – deciding how and when to rebalance. We want to get you as close to your ideal portfolio as possible in as few trades as possible.

Thinking About the Tradeoffs

With so many hurdles to perfectly rebalancing your portfolio, we carefully consider how we prioritize the rebalancing decision. Just like you start from the top down when you decide on asset allocation, we do the same when we rebalance.

The most important thing is getting the ratio of equity to fixed income correct. Since this ratio is the main driver of the level of risk you are taking, we want to be sure we get it right. From there, we want to find the right balance between domestic and international securities, and then move on to balancing specific asset classes. This hierarchy allows us to manage the rebalancing frictions and still make sure you are taking the right level of risk in your portfolio.

A good balancing act doesn’t end there. The other thing we always seek to take full advantage of is cash flowing into or out of your portfolio. When you are regularly either saving in or spending out of your portfolio, we use that to your portfolio’s advantage. If you’re saving and putting money into the portfolio, we’ll buy the most underweighted asset classes; if you’re spending, we’ll sell the most overweighted asset classes. “Official” rebalances are still needed occasionally, but regular cash flows make rebalancing a whole lot smoother.