Rebalancing Your Portfolio / Recognizing Your Earnings

Feb 20, 2007 by

Imagine that on January 1st, 2006, you invested $2,000 in Stock A. On January 1st, 2007, your investment was worth $3,000. On that day, you asked yourself, “How much money am I risking in the market?” The answer to this question all depends on how you perceive capital gains. Your perception of your gains may change your behavior. If you have not yet sold an investment, the IRS (Internal Revenue Service) has not recognized your gain. You only have to pay capital gains taxes on an investment after it has been sold, and only if it has been sold at a capital gain (not at a loss). However, you don’t have to perform your mental accounting in the same manner as the IRS. You only have to pay capital gains taxes on the investment after it has been sold, and only if it has been sold at a capital gain (not at a loss). However, you don’t have to perform your own mental accounting in the same manner as the IRS. If in January 2006, you bought $2,000 of two stocks, A and B, and felt that you needed to keep an evenly balanced portfolio, you might fear that your portfolio has come out of balance at the beginning of January 2007. If Stock A increased in value to $3,000, but Stock B did nothing (remained at $2,000), all of a sudden, you would have a portfolio that was 60% A, 40% B. If you had a strict rule of investing 50/50 between the two stocks, you might feel compelled to sell $500 worth of Stock A, and then to invest that money in Stock B. While that would give you a more balanced portfolio, and expose you to less risk from Stock A, it would also increase your exposure to Stock B. Before doing this, it is important to ask yourself if it is a good idea to increase your exposure to Stock B. Is there something about Stock A that has caused it to perform well in the past, and will continue to cause it to perform well (relative to B), or is whatever increased its price in the past now “priced into” the stock price, resulting in no abnormal returns in the future? If there was something special about Stock A, this rebalancing might be very harmful, as it would cause you to own less and less of the better performing stock over time.┬áHere are two illustrative scenarios:

No Rebalancing; Stock A Grows 50% per Year, Stock B is Stagnant
January 1st, 2006: $2,000 Stock A and $2,000 Stock B
January 1st, 2006: $2,000 Stock A and $2,000 Stock B
January 1st, 2007: $3,000 Stock A and $2,000 Stock B
January 1st, 2008: $4,500 Stock A and $2,000 Stock B
Final Value: $6,500

Rebalancing; Stock A Grows 50% per Year, Stock B is Stagnant
January 1st, 2006: $2,000 Stock A and $2,000 Stock B
January 1st, 2007: $3,000 Stock A and $2,000 Stock B
January 2nd, 2007: $2,500 Stock A and $2,500 Stock B
January 1st, 2008: $3,750 Stock A and $2,500 Stock B
Final Value: $6,250

What’s the bottom line? If you recognize your gains along the lifetime of your investment, and use your recognition to rebalance your portfolio, you will sell your winners and buy more of your losers (assuming you wish to keep them in equal proportion). If there is some real reason why the winners are winning and the losers are losing, you will reduce the performance of your investments. Also, you will suffer transaction fees and tax consequences along the way. If you sell some Stock A and reinvest the money in Stock B (the worse performing stock), you will have to pay capital gains taxes on the sale of Stock A, as well as a commission to sell the Stock A and another commission to buy Stock B. That’s a lot of fees! So, the moral of the story is that rebalancing must be considered very carefully.

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