I'm rebalancing my portfolio. What do I sell?

By Walter Updegrave, senior editor


(MONEY Magazine) -- I've read a lot about the benefits of rebalancing your portfolio annually, but I've never seen the answer to these questions: How do I decide which stocks to sell? And when should I "wait it out," assuming that a good stock will rise back to its pre-crash price, as opposed to pulling the trigger and accept a loss? -- Chris, Long Beach, Calif.

As another year winds down, investors' thoughts naturally turn to reviewing the health of their portfolio and getting it in shape to face the New Year.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

And for many people that means rebalancing and poring over their holdings with an eye toward letting the dogs out, so to speak, and possibly harvesting capital losses that can lower their tax bill for 2010 (assuming losses are booked by the end of the year).

Let's start with rebalancing and then move on to the other issue you've raised.

If you've already read a lot about it, then you know that the main point of rebalancing is to restore your portfolio to the diversified blend of stocks and bonds that you previously set based on your investment goals and risk tolerance.

If different parts of your portfolio post dramatically different returns, the mix you originally set can get knocked out of whack and make your portfolio more risky or less risky, depending on how different holdings performed.

In 2009, for example, stocks gained roughly 29%, while the broad bond market returned about 6%. So assuming interest, dividends and any other distributions were reinvested and no other money was added, a portfolio that started the year with 60% in stocks and 40% in bonds would have ended that year about 65% in stocks and 35% in bonds.

You could have brought such a portfolio back to its original 60-40 blend by selling off some of your stock position and putting the proceeds into bonds.

Or, since the proportions weren't off that much, you could simply have invested new money in the part of the portfolio that lagged, an approach that, in taxable accounts, has the advantage of not triggering any tax liability if you sell securities with a gain.

Unless things change dramatically between now and the end of the year, the disparity in returns between stocks and bonds in 2010 probably not be large enough to tilt your portfolio's balance dramatically. Which means rebalancing might not be such a big priority this year.

That said, rebalancing may still be in order if you've skipped this exercise a few years or more. And even if you've been diligent about rebalancing, you may still need to do some fine-tuning if a substantial part of your holdings have done especially well this year (as is the case with small stocks, real estate funds and precious metals funds) or fared poorly (bear market funds, market neutral and currency funds). Here are more practical details on rebalancing.

Now let's move on to the second part of your question.

Anytime you rebalance it's also a good idea to see whether you should be jettisoning any of the stocks, funds or other securities you own. I'm not advocating selling just for the sake of doing something; indeed, as I've noted previously, the fewer moves you make, the better off you're likely to be.

But selling can make sense if you have investments that no longer fit your strategy or you're not confident certain ones will deliver gains commensurate with their risk. You may also want to sell simply to use the opportunity to turn a loss into a tax break.

Sometimes, this sort of investment housekeeping can jibe nicely with rebalancing. For example, if you need to lighten up on equities to fix your mix and you know what stocks you want to cut from your portfolio, you may be able to kill two birds with one stone: get rid of the stocks and simultaneously achieve the new balance you seek (or at least get closer to it) by investing the sale proceeds in bonds.

But things don't always work out so neatly.

In some years, while rebalancing may require that you boost the percentage of your portfolio that's invested in stocks, you may also want to rid yourself of some stocks you no longer favor. That puts you in the position of having to sell certain stocks while also adding to your overall stock stake.

In either case, if you're selling at a capital loss, you can use that loss to lower your tax bill by offsetting realized capital gains in other investments or even by applying the loss to regular income-provided you follow the various rules and regulations Uncle Sam has laid out for such situations and assuming you're investing in a taxable account. (As I've explained before, the opportunities for deducting investment losses in IRAs and such are extremely limited.)

This still leaves us with the issue of deciding which stocks or other securities to sell and, if you own an investment that's worth less than you paid for it, whether to sell for a loss or wait for it to bounce back.

Essentially, the decision of whether to hold onto a specific security (be it a stock, fund or bond) or get rid of it is a judgment call. But the basis on which you make that judgment isn't how the security performed in the past or whether you're sitting on a gain or a loss. It's what you think of its future prospects.

Waiting or hoping for it to get back to even has no effect on its performance looking ahead. Ditto for holding onto an investment for fear of "locking in losses." A stock doesn't know or care whether you're sitting on a gain or loss. So that's irrelevant.

Take the case of General Motors. I don't think anyone would buy shares in this company based on how it performed (or, more accurately, underperformed) in the past.

The reason GM had a pretty successful IPO and has (so far at least) managed to stay above its $33 initial offering price is that investors are relatively sanguine about its future.

Whether that assessment is justified, we'll have to see. But the point is that if you're not comfortable evaluating such factors as a company's earning power, the value of its assets and the quality of its management -- and then gauging them against other alternatives -- then I don't see how you can make an informed decision about whether to buy or sell a stock.

Without that kind of analysis, you're engaging in mere guesswork.

All of which is to say that I can't tell you when it's better to hold or pull the trigger. I know that you can find plenty of articles giving tips or guidelines for selling (sell after it's gained a certain percentage, or lost a certain percentage or its earnings growth has zoomed above expectations or slowed below them, etc.).

But IMHO, it's virtually impossible to apply such tips to specific situations. Ultimately, you have to make a call based on your analysis of a particular investment's future prospects-and how those prospects stack up vs. other places you can put your money.

I'm not saying this sort of assessment is beyond the abilities of individual investors. It's not. But it does require a larger commitment than most people are probably willing to make.

Which is why I think most investors are better off in mutual funds (and broad based index funds, in particular), as such investments free them from having to engage in the nuts and bolts of security analysis.

So to sum up, I suggest you use the last couple of days of the year to decide whether you need to rebalance your portfolio. At the same time consider whether there are some securities you want to get rid of.

If you do have some you want to jettison-and you hold them in taxable accounts-selling before the end of the year will allow you to claim the loss for the 2010 tax year.

And while you're at it, don't forget that if you're sitting on a loss in a security you still think has a bright future, you can always sell it to book the loss and then buy it back again. Just be sure you don't violate the IRS's "wash sale" rules, which put the kibosh on all or part of your loss deduction if you sell for a loss and buy the same or a substantially identical security within the 30 days before or after the sale.

If this combination of rebalancing and evaluating the future prospects of your holdings involves more time and effort than you're willing to devote to your finances, then you may want to consider simplifying your investment approach and investing mostly or wholly in broad-based index funds. To top of page

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