As of the end of April 2015, over the prior six year period, the S&P 500 Index has risen an eye-popping 170.84%, a remarkable feat by any standard. Yet, even more intriguing than the magnitude of the market’s post-crisis rise has been the way in which it has gone about it, an almost effortless and smooth trek up due to easy monetary policy and weak economic recoveries abroad. While we still believe equity markets remain relatively attractive, especially considering the historically low yields currently being offered by bonds and the many positive economic reports being released in regards to housing starts and the labor market, Condor Capital recently began to lock in profits.
Allowing the equity allocation inside a portfolio to run during the post-crisis bull market has proven to be a fruitful strategy, but with years of gains accumulating on paper, now is a great time to ring the register and turn those paper gains into realized gains. After all, the whole point of investing is to sell high and buy low. Strategically rebalancing the portfolio allows investors to do both. Not only do you lock in profits by trimming your equity holdings when they have had a nice run up, but you also give yourself the opportunity to rebalance at depressed prices if equity markets weaken and the equity allocation has subsequently deflated. However, as is the case in most parts of life, there is a caveat to rebalancing a portfolio: taxes.
Investors should always remember to never let taxes dictate their investment strategy. While no one genuinely enjoys paying Uncle Sam, owing taxes on capital gains is really a double edged sword. On one hand, they are a reward for making wise investment decisions. After all, an investor wouldn’t owe them unless he/she made a profit. Nonetheless, it may feel as if the investor has to chip away at hard earned money to pay this tax. Luckily for investors, capital gains tax rates are generally lower than ordinary income tax rates, with the highest rate an individual investor could owe on long term capital gains being 23.8% (including a 3.8% unearned income Medicare tax) compared to a 40.5% (including a 0.9% earned income Medicare tax) on ordinary income. On occasion, investors may have the opportunity to lower their capital gains by using either tax-loss harvesting strategies or tax-loss carryovers from prior years, but with six consecutive years of market gains, most have no such options available to them.
Additionally, by rebalancing and paying the applicable taxes on any gains, an investor allows him/herself the opportunity to adjust the portfolio back to his/her target level of risk. As time passes and unrealized gains/losses accrue, a portfolio’s asset allocation will typically change as well. For instance, consider the market’s most recent rally and the simultaneous effect it has had on the composition of many investors’ portfolios. While individual stocks have appreciated in value, equity allocations have also risen. As a result, the level of risk inherent in many portfolios may have increased to levels that are not suitable for every type of investor. In this situation, an investor would benefit greatly by taking some chips off the table and reducing his/her portfolio’s equity allocation.
At the end of the day, despite having to pay taxes, the pros of taking profits and rebalancing a portfolio far outweigh any possible cons.