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Rebalance Through Profit Taking

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In How to Rebalance an Investment Portfolio [4], I stated that it is generally preferable to reallocate future acquisitions rather than divesting existing assets to get back to your target asset allocation.

A big reason for this is to defer capital gains taxes payable from selling outperforming assets. The longer you keep your wealth in your possession, the better your compound returns [5] will be. This is a problem when triggering taxes on asset sales. 

This holds true for investors who are slowly and consistently building well-diversified portfolios. The goal is to amass large positions over multiple years while generating market returns and minimizing costs. It is not to try and time markets or asset volatility by jumping in and out of individual non-diversified investments, creating heavy transaction costs and taxes.

That is the general principle.

At times though, one may be better off divesting the assets which have done well and paying the taxes.

Non-Diversified Portfolio

Many investors maintain poorly diversified portfolios. As a result, it may make some sense to divest outperforming assets rather than try to simply adjust future investments.

Amongst other things, a well-diversified portfolio is one in which no individual investment has substantial impact on the portfolio as a whole.

For example, you and your brother both own shares of Apple Inc. (AAPL).

AAPL is one of 20 stocks in your brother’s portfolio and accounts for about 4% of the equity component of his assets. That suggests that the portfolio may be diversified (note that other factors need to be reviewed before a conclusion can be reached).

Whereas you only hold 4 stocks in your equity investments and AAPL makes of 30% of your holdings. If the AAPL share price increases or decreases by 20%, the impact on your portfolio is significantly more than on his portfolio. Your portfolio is not well diversified (regardless of other factors).

This can have a few ramifications.

One Stock May Dominate

If AAPL increases quickly in price versus your other holdings, you may find that it has become 50% or more of your portfolio.

This is the “too many eggs in one basket” concern.

In contrast, an increase in AAPL share price will have less impact on your brother’s portfolio.

However, your portfolio becomes too reliant on one investment. If the share price falls, your entire portfolio suffers.

As to what constitutes “too many eggs”, that is up to the risk tolerance of the investor.

I would suggest though that no single asset (note that diversified investments such as funds are excluded) should make up more than 20% of one’s portfolio. And, in most cases, the percentage should be much less.

Abnormal Returns

Perhaps you own shares in 5 different companies. The benchmark market index returns 20% for the year. 4 of your 5 shares return between 15 and 25%, Yet one company has increased by 200% during the year.

As above, you may find that this one company now dominates your portfolio.

But there is another potential issue.

Perhaps there is a reason for the company’s shares to appreciate this much. Maybe they developed an innovative product, discovered a huge reserve of natural resources, etc. Or maybe the company has been over-hyped and is due for a correction in price.

Depending on your analysis and conclusions, you may wish to take some profits in case the share price falls.

There are a variety of ways to trim your holdings in a single company.

You could sell everything and realize a large profit. In our example, 200% over one year before taxes.

Or if you think there is further upside, but are not certain, you could sell a portion of your holdings.

Perhaps you bought 1000 shares at $10 per share. After one year, the share price has climbed 200% to $30. If you sold 334 shares, you would have completely recovered your initial investment. You could hold the remaining 666 shares forever, knowing that they are “free”.

Or, if you are more risk averse, you could sell a higher percentage. By selling 500 shares at $30, you would realize $15,000 before tax. A 50% gross return on your initial investment. You now have less for future appreciation, but a 50% realized gross return and 500 “free” shares remaining is not too bad.

Investment Bubble

A single asset, market, or market segment that increases substantially in price might be prime for an investment bubble.

An investment bubble may be foreshadowed by abnormal returns in an asset or group of assets.

Look at the dot.com investment bubble and its crash in 2000. Your specific investments might have been solid companies, but they would have been caught up in the panic selling. The same is true with U.S. housing prices. Many excellent houses are selling at discount prices simply because the market as a whole is in difficulties.

Even if you think your own individual investments are solid, to protect your portfolio it might be wise to sell a portion of your holdings in that asset or market segment.

Again, the percentage to sell depends on your analysis and conclusions, as well as your personal risk tolerance.

Summary

At times, it may be worthwhile to rebalance your portfolio by selling individual assets.

The costs of taxes payable might be worth the value you get by having one asset dominate your holdings and the resulting risks that come from having a weakly diversified portfolio.