Don’t sabotage your strategy
If you choose not to act on your portfolio because you don’t want to pay taxes, you risk sabotaging a sound—and consistent—investment strategy. I see 2 dangers here:
- Taking on too much risk. Let’s assume a hypothetical investor had a 60% stock, 40% taxable bond portfolio at the beginning of 2005. The 2006 market returns had him walking on air, and he didn’t want to pay taxes on capital gains after rebalancing. Then, life got busy and the global financial crisis hit. He couldn’t bring himself to look at the damage, but he didn’t sell out either. That doesn’t necessarily mean mistakes weren’t made. Because he didn’t rebalance after 2006, his portfolio edged closer to 70% stocks just before the bear market calamity. His portfolio would have experienced a cumulative loss of 31.18% between 12/31/2007 and 03/31/2009, which is 4.59 percentage points higher than a 60/40 split.2 But the bad news doesn’t stop there. Without rebalancing during the bear market, his portfolio likely fell to below 50% stocks by March 2009. Thus, his portfolio can’t recover as quickly as stocks began to rebound. According to our research, that mistake would have cost the investor several percentage points of return.3
- Developing a concentrated portfolio. If you don’t rebalance your portfolio, it could become more skewed toward individual high-performing investments. In this case, your portfolio is more subject to increases in volatility and possible underperformance if that investment falls out of favor. We recently published a great research paper on concentrated equity positions that I recommend to all my clients in this scenario to help them come up with an action plan.4
Change of mindset
I also hear justifications for ignoring rebalancing from investors. Some consider rebalancing a nuisance. Others want to stay with their stock allocation because they think the stock market will continue rising. But we believe rebalancing is part of a sound investment strategy. I often remind clients that “staying the course” (another tenet of our investment philosophy) isn’t only a passive phrase used to prevent you from selling out when things look ugly. Staying the course means staying dedicated to the habits that’ll help you reach your goal. Ultimately, minimizing risk is the aim of rebalancing. You may still capture meaningful returns while being consistent with a target asset allocation and rebalancing strategy. In fact, there’s evidence to support that there’s little economical value in avoiding a capital gain. According to Michael Kitces on his Nerd’s Eye View blog, for an investment with a 20% to 30% gain, the annual “value” of avoiding that capital gain is close to a single day’s worth of volatility in the stock market.5 Vanguard has researched a variety of rebalancing strategies. While there may not be a clear optimal strategy, we believe having a strategy is better than not having one. Most rebalancing strategies rely on one trigger that’s based either on timing or a specific shift in asset allocation. In Vanguard Personal Advisor Services®, we use a “time-and-threshold” blend for our rebalancing strategy. We review the portfolio quarterly and rebalance if its asset allocation has deviated by 5 percentage points or more. Blending these triggers results in a more complex strategy, but it has merit. If we use this strategy on a 60% stock, 40% bond portfolio, the average portfolio turnover would be about 1.95%2 and average Sharpe ratio about 0.51. This shows that rebalancing can help you mitigate your risk while spreading out rebalancing events over time.
Just do it
That’s why we recommend rebalancing—even if it means paying taxes on capital gains. You’ve worked hard to invest your money and see it grow. Claim your prize! In a future blog post, I’ll address some of the more complex investment management techniques that you can use to help reduce your tax liabilities.
1Until exemptions enacted through H.R. 5946 in October 2016, all Olympic and Paralympic medalists were taxed on the value of the Olympic medal as well as the earnings they received from the U.S. Olympic Committee for winning. This exception does not apply if an Olympic medalist has an adjusted gross income in excess of $1 million.
2When determining which index to use and for what period, we selected the index that we deemed to be a fair representation of the characteristics of the referenced market, given the information currently available. For U.S. stock market returns, we use the S&P 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. For U.S. bond market returns, we use the S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; the Bloomberg Barclays U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg Barclays U.S. Aggregate Float Adjusted Index thereafter. For U.S. short-term reserves, we use the Ibbotson U.S. 30-Day Treasury Bill Index from 1926 through 1977 and the FTSE 3-Month U.S. Treasury Bill Index thereafter.
3Source: Vanguard. Getting back on track: A guide to smart rebalancing
4Source: Vanguard. Is dilution the solution? Considerations for a concentrated equity portfolio
5Source: Michael Kitces. Capital Gains Strategies For Highly Appreciated Investments After A Big Bull Market Run
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.