Selling stocks at a loss can be a tough decision to make: no one wants to admit that they made a bad investment. Come tax time, however, strategically realized losses can help lower your capital gains tax liability, thanks to a strategy known as tax loss harvesting.
With tax loss harvesting, an investor sells a security at a loss, and by realizing that loss, offsets some of the taxable gains from the same year. The investor then typically replaces the security they sold with a similar one, in order to remain in line with their target asset allocation, while taking care to avoid wash sales.
“It makes sense if you have a lot of short term gains,” says Mark Tan, a financial advisor at Thrivent Financial.
Higher earners benefit more
Investors in higher income tax brackets see more benefit from tax loss harvesting, as they typically have a higher capital gains tax rate and have more liquid assets to invest.
According to Aaron Gubin, head of research at SigFig, this strategy is most beneficial for investors who have taxable accounts exceeding $100,000 and make reasonably large, continual deposits throughout the year.
That’s because any time an investor sells a stock to realize a loss, they effectively reset their cost basis to a lower level. In order to perform tax loss harvesting again, that investor should purchase stocks at a higher price in the future, and then sell again at a loss further down the road, to offset the gains. (If it sounds complicated, it can be. Investors considering this strategy should consult with a tax or accounting professional for advice pertaining to their specific situation.)
According to SigFig data, 26% of investors with portfolio values between $250,000 and $1 million engaged in behavior indicating possible tax loss harvesting in 2014 (they executed 30% or more of their annual trades in December). Among investors with portfolio under $250,000, only 11% engaged in this type of behavior.
Think of tax-loss harvesting as an year-round strategy
Many investors engage in tax loss harvesting at the end of the year, but it should really be a year-round strategy, according to John Sweeney, executive vice president of planning and advisory services for Fidelity Personal and Workplace Investing. “There is market volatility all year that presents opportunities,” he says.
However, investors should be aware of the costs, such as transaction fees incurred when making trades, or redemption fees charged by some funds if a position is eliminated during a holding period.
Additionally, wash sale rules prevent investors from claiming a loss on a security, if they end up buying it again within 30 days of selling it.
At the end of the day, while tax events matter, investors should not make moves solely for the sake of reducing their taxes. Selling a stock at a loss just to offset gains means you might miss out on appreciation in the future. “Don’t let the tax tail wag the investment dog,” says Sweeney. “Make your investment decision first, and think about the tax consequence second.”
Portfolio rebalancing is a topic investors come across often. The advice may vary depending on whom you ask, but most financial advisors tend to touch on two main issues: how often to rebalance and when.
Equally important is when and why not to rebalance. Rebalancing is a strategy to maintain one’s asset allocation in line, should significant market swings or dividend payments affect it. It should not be a knee-jerk or emotional reaction to every market move, and it should most definitely not be done in the pursuit of the next hot investment opportunity.
“Rebalancing won’t increase the rate of return,” says Michael Brady, founder and president of Generosity Wealth Management in Boulder, Colo. “The purpose of rebalancing is to stick with the plan.”
Not only might overly frequent rebalancing increase investment costs, but it also risks cutting off a cycle before it runs its course, Brady explains. “Whether the cycle is multiple quarters or multiple years, you’ll never catch the upward cycle if you are always shifting away from the downside,” he says. Not to mention that rebalancing could create a tax situation if it causes short-term realized gains.
Is rebalancing necessary?
When it comes to rebalancing, there are two schools of thought. Some investors avoid rebalancing entirely. “I don’t think there is any great data out there that says investors need to do it at a particular interval,” says Jeff Tjornehoj, a senior research analyst at Lipper. “Both [stock and bond] markets tend to perform well over time, with stocks moving up and bonds producing income,” he explains. “Non-balancing is a hands-off approach.”
Others argue that rebalancing forces you to pay attention to and understand your portfolio. “If you don’t rebalance, you end up having a lopsided portfolio,” says John Piershale, wealth advisor at Piershale Financial Group.
1. Calendar rebalancing
This is the most common rebalancing strategy among everyday investors. With calendar rebalancing, an investor picks a time interval to review their portfolio and make adjustments, if needed, to get investments back in line with their original allocation. Calendar rebalancing can happen quarterly, yearly, or once every few years. For average investors, Brady says rebalancing on an annual basis is sufficient to prevent the portfolio from deviating too far from the original plan.
2. Asset class rebalancing
In a properly diversified portfolio, the investor’s assets are spread among several asset classes. An appropriate time to rebalance is when one or more of those asset classes’ share of the portfolio deviates by a wide enough range.
For example, say your ideal stock-bond allocation is roughly two-thirds in stocks and a third in bonds. But in a year, the stock market rises 20% and bonds fall 20%. This would bring your allocation to ¾ stock and ¼ bonds: a much riskier portfolio than where you started. Rebalancing will take care of the deviations from your ideal portfolio by buying when prices are low and selling when prices are high, says Aaron Gubin, director of research and wealth management at SigFig.
3. Glide path rebalancing
Glide path rebalancing is essentially the strategy of target-date funds. The portfolio’s asset allocation is determined with a specific retirement date in mind, and becomes more conservative as this date approaches.
With many people living thirty years or longer in retirement, glide path rebalancing can also play a role in making sure the investment portfolio is generating decent returns, while protecting their savings. For instance, Brady says an investor might have 40% of their portfolio in equities in the first ten years of retirement, then pare their equity position down to 30% in the second ten years, and 5% for the remainder of their lifetime.
Rebalance for the right reasons
At the end of the day, rebalancing should be about keeping your investments in line with your investment goals and strategy. Whether you do it based on a predetermined time or age, the key is to make sure it keeps you on track with your plan.
Be tax- and cost-efficient
One of the strongest arguments against frequent rebalancing is that, much like with market timing, the investor is likely to incur trading costs, and possibly trigger short-term capital gains if they sell assets held less than a year. One way to rebalance with taxes and costs in mind is to utilize cash dividends and fresh cash deposits to do “sale-free” rebalancing, says Gubin. “We spend fresh cash on the most underweight security to bring it back up to its target weight, without having to sell assets that are overweight,” he explains. “This is tax- and trading cost-efficient because we don’t have to sell anything, or execute unnecessary trades. We can buy assets with the new cash to keep client portfolios on track.”
In sports, supporting the home team can be a rewarding experience that brings together fans from all walks of life.
In investing, a similar sentiment often manifests in portfolios in what is known as home bias: the tendency to favor domestic equities over international equities.
A recent analysis by SigFig found that the median investor has 61% of their portfolio in domestic equities, and just 6.6% in international equities. (The rest is other asset classes, including fixed income, cash and cash equivalents, REITs, etc.) Yet, U.S. stocks represent just over 35% of the global equity market — which means that international publicly-traded companies represent two-thirds of the world economy, at least as far as market capitalization is concerned.
One of the main factors behind home bias is a preference for investing in what you know, and avoiding what you don’t. “There is a mindset of buying stocks you are familiar with,” says Sheryl Garrett, a financial planner and founder of the Garrett Planning Network. “Well, that’s really hard to do when you’re thinking of investing internationally. We might be familiar with Swiss chocolates, European vacations or German cars, but we don’t know much about companies in even developed countries, and particularly in underdeveloped countries.”
Ironically, while ignoring international exposure might make an investor feel safer, its effect on a portfolio’s volatility is quite the opposite. Because international markets don’t necessarily move in the same direction as the U.S. market, adding international exposure to one’s portfolio would lower its riskiness, not increase it.
Affluent investors have less home bias
Not everyone is equally averse to international stocks. In SigFig’s data analysis, portfolio size was a key differentiator in how much exposure to international markets investors have.
Simply put, the larger a portfolio, the larger its international exposure. While the median international equity share of portfolios between $20,000 and $100,000 was 6.4%, that of portfolios between $100,000 and $400,000 was 8.4%. Portfolios of $20,000 or less had just 0.5% in international equity.
So do Millennials and Gen X-ers
Whether it’s growing up in the age of the Internet, entering the workforce when collaborating with global teams is par for the course, or they simply have more tolerance for risk (or what is perceived as risky, anyway), investors who are 20 to 39 years old have significantly more international exposure than investors who are 60 and older: 12.2% vs 8.1% of portfolio, respectively.
Another possible reason is that older investors are simply less familiar with international equities, says Stella Huh, a data scientist at SigFig. “They were born in and lived in a time when the United States dominated the world economy.”
Keep your eyes on the long-term prize
Taking a disciplined approach is hard, especially when you compare how the US stock markets have performed in recent years to those overseas. The S&P 500 gained 11.39% and 29.60% in 2014 and 2013, respectively (not including dividends), while in the same years, the MSCI Emerging Markets Index was down -2.2% and -2.6%.
There are, of course, legitimate concerns with international investing: political uncertainties, accounting irregularities, corruption, and conflict. That’s normal. However, Garrett argues, countries behave much like companies: one country that used to be an emerging economy is now developed, and now others are coming along. “There are always going to be bad parts of the world that will be challenging, but that doesn’t mean that we should ignore them,” she says.
So how much of a portfolio should be in international investments? Depending on an individual’s age, net worth, risk tolerance and other circumstances, SigFig’s Head of Research and Wealth Management Aaron Gubin recommends that investors hold at least 50% of their equity positions in international investments. “The markets are making a judgment call where to put their money,” he says. “And global markets are saying, 60% to 65% of our money should be in the rest of the world.”
This article was originally published on US News & World Report.
Last week according to schedule, the Federal Reserve Bank’s Open Market Committee met and agreed to leave interest rates untouched at 0% – 0.25%, with a hint that they would raise rates by the end of the year. What should investors do about this, especially those with significant fixed income holdings?
I argue that the answer is, “not much.” While it’s true that bond prices move in the opposite direction as rates, different factors affect how much those prices adjust, and the impact on a portfolio can range from “some” to “almost negligible.”
First, why do rates and prices move in the opposite direction? The intuition here is straightforward: if rates rise, bond buyers would rather own new bonds that pay at higher interest rates than old bonds that are paying at lower interest rates. Thus, as interest rates rise, the price of bonds already in the market start to fall.
Conversely, when interest rates fall, bond buyers would rather hold old bonds that are paying higher interest than new bonds that pay lower interest rates. Thus, as interest rates fall, bond prices rise, all else being equal.
Though it is clear which direction bond prices will move as interest rates move, the rate change alone doesn’t speak to how much the prices will move. For this, we look to the “duration” of the bond holdings. Duration, simply, is a measure of the time a bond will pay interest and principal back to its holder.*
Consider how investors might view holding a short versus a long duration bond as rates rise: they’re much less likely to want a low interest paying bond for a long period of time than one where they’ll get their principal back fairly soon. Thus, the longer the duration of the bond, the more the bond’s price will be affected by the rate change. Again, this logic makes sense, all else being equal. As an approximation, a quarter-point increase in rates would produce a decline in the price of a five-year duration bond of about 1.25% (0.25% * 5 = 1.25%).
SigFig Asset Management expectations: Short Duration Fixed Income asset classes prices fall a little, but won’t collapse
For SigFig’s Asset Management clients, the duration of the fixed income ETFs is an important consideration. Our current allocations use Short-Term US Treasuries, with duration of approximately 1.8 years, while our broader US bond holdings have an average duration of approximately five years.
The Federal Reserve’s statement indicates that they expect to increase rates slowly, starting sometime before the end of the year, as the US economy continues to improve and settle on firmer footing. The Fed’s meeting notes suggest an expectation of 0.5% – 0.625% by the end of the year. Furthermore, they expect to raise rates very slowly over the next couple years.
Putting this in more concrete terms, if rates increase by one-half percent this year (with all else being equal), we may expect our Short-Term US Treasury and broader US Bond holdings to fall by approximately 1% and 2.5%, respectively.
For well-diversified portfolios, holding bonds still makes sense
Within the context of a well-diversified portfolio, it is reasonable to continue holding bonds in the face of a rate increase.
First, the impact to the total portfolio could be relatively small: though a 60/40 stock-bond portfolio might see the individual bond positions lose 1% – 2.5%, the total portfolio’s value could fall by less than 0.75%, even if the equity positions are unchanged.
Second, fixed income assets continue to provide diversification benefits to the equity positions in the portfolio.
Third, a rate increase would be good news, because it signals that the Federal Reserve believes the economy is growing stronger, with increasing evidence that the recovery is sustainable. Moreover, increasing economic stability suggests that borrowers (bond issuers) are more likely to repay their holdings (i.e., they are more creditworthy) and that could actually decrease their borrowing costs.
Finally, potential losses in fixed income are offset by the possibility that US bond values increase because of global macroeconomic instability (e.g., Greece-Eurozone concerns, Russian-Ukrainian war) as investors seek higher quality investments.
SigFig’s Investment team continues to watch the Federal Reserve’s actions with interest. We view that future rate increases signal the Fed’s belief in the growing strength of the US economy, which bodes well for company profits, equity prices, and consumers. In sum, pending rate adjustments do not mean an impending collapse in bond prices; the reality of bond price movements is complex and multi-faceted, and so bonds remain an important piece of a balanced portfolio even in the face of potential interest rate increases.
*The duration is typically shorter than the bond’s maturity, because the bond will usually pay interest back to the holder periodically before repaying the principal back at maturity, but since the principal repayment is usually the largest cash flow back to the investor, that last payment is weighted the most heavily.
If you have recently researched investment management services, chances are that you have come across the term “robo-advisor.”
Who are these robo-advisors and can you trust them with your financial future?
A robo-advisor is an online investment platform that uses algorithms to determine asset allocations for investors and manages their investment dollars with minimal human intervention. Because it utilizes technology rather than active management by a human, robo-advisors charge significantly lower fees than what most financial advisors typically charge.
“It’s a fast growing business today, with something close to $20 billion in assets under management,” says David Larrabee, director at CFA Institute, the association of investment professionals. “Robo-advisors are here to stay and have demonstrated there is demand.”
According to recent research by A.T. Kearney, approximately $2 trillion will flow into robo-advisor platforms over the next five years.
What is driving the explosive growth in the robo-advisor marketplace? Experts point to the demographics, account sizes, and low costs as the main factors.
Demographics: Investors of all ages are using robo-advisors, but not surprisingly, they are especially popular among millennials and Generation Xers who grew up with technology and would feel just as comfortable firing off an email or texting as they do talking to a human being.
Lower account minimums: Furthermore, most wealth management firms require investors to have a minimum of $100,000 or more in investable assets. Robo-advisors have investment minimums in the low four-digit numbers; some have none. “The traditional investment advisory accounts’ minimum of $100,000 puts these advisors out of reach for a lot of investors,” says Larrabee. “Robo-advisors are stepping up to fill that void.”
Lower fees: Last but not least, robo-advisors are inexpensive. While traditional wealth management services charge 1% of assets under management or more, the typical fee charged by a robo-advisor is 25 basis points or lower, depending on account size.
How Robo-Advisors Work
With a robo-advisor, clients open an account and typically start by answering a series of questions about their age, tolerance for risk, and investment goals. The platform provides an asset allocation based on their answers. An older investor nearing retirement, for example, will be recommended a more conservative asset allocation than a younger investor who will be working for decades to come.
Low-cost index investing keeps emotions out of your investment strategy
Robo-advisors typically do not trade individual stocks or offer specific stock trading advice. Rather, they tend to invest in low-cost ETFs, which provide instant diversification, as well as tax efficiency.
Most robo-advisors adhere to a buy-and-hold, passive investing strategy. They do not pick stocks or try to time the market. Instead, robo-advisors are charged with figuring out the exposure investors should have to stocks, bonds, international investments, and other asset classes, and use each individual investor’s age, expected retirement date, and risk profile to come up with an asset allocation and stick to it, regardless of day-to-day market movements.
Account rebalancing keeps your investment goals on track
Although robo-advisors do not react to stock movements, they do track the markets on a daily basis. If market swings move clients’ portfolios out of balance with respect to their recommended asset allocation, they rebalance accordingly, while being mindful of creating taxable events or incurring trading fees.
As a result, investors with these platforms do not have to get on the phone with their money manager if one company is driving an entire sector down. They can rest assured that, provided that they are in a properly diversified portfolio, they will be able to stay the course and ride out any market downturn.
Investors who need estate planning or have complex investment portfolios may want the hand-holding that comes with a financial advisor, or simply find a good lawyer and then choose low-cost index funds or ETFs on their own. For many investors, however, robo-advisors offer a way to grow their investment nest egg without getting hit with high costs and fees.
Numerous studies have shown that, over time, active investing underperforms a passive approach. There are several contributing factors, including:
So why doesn’t everyone invest passively? Taking the long-run view requires patience, and marketing is a powerful lure. Investors don’t want to match or slightly trail the returns of the market (when you factor in expenses); they want to beat the market, and that is something a passive index fund by definition cannot do. Instead, they fall for a good story: a team of smart investment professionals who have a secret strategy or the latest technology can deliver better than the market’s returns.
The reality is, there are three basic ways to make money investing in markets:
- Find undervalued opportunities before everyone else.
- Invest in the broad market over the long run, as through long-run economic gains, companies across a market deliver increasing value to their owners.
- Minimize costs.
Searching for undervalued assets has a strong, but illusory lure; the wealth manager just has to be smarter and faster than everyone else. The problem is that there are literally thousands of money managers, all looking for undervalued opportunities. The New York Times reported that over the six year bull market (2009 – 2015), not a single manager (out of 2,862 stock market funds) could sustain performance ranking in the top quartile of managers for all six years.
Even if a fund manager successfully tops the market for a few years, it’s very difficult to sustain that outperformance over a long period of time. Put simply: it’s extremely difficult to outsmart everyone consistently enough to beat long-run passive index performance. If it’s impossible to find a consistently excellent fund manager, why should investors pay high fees to the fund?
Index funds, on the other hand, don’t try to outsmart the market. By purchasing everything in the market index in the proportions the securities comprise the index, the fund manager aims to match the market’s performance. Some assets will increase in value, some will fall, but in sum, the index fund performance matches that of the market.
Moreover, with index funds or ETFs, investors capture value through long-run broad market gains while minimizing costs. Index funds pass on lower costs to their investors, because management costs are lower, transactions costs are less frequent, and taxes tend to be smaller.
Using an active fund manager puts higher costs on the investor: the fund manager receives a large salary, paid through the expense ratio (often 1% or more of the investor’s managed assets); fund trading costs, which may be high as the manager trades frequently in search of opportunities; and higher taxes. Even if the active manager is successful at beating the benchmark, these extra costs can often outstrip any gains for the investor.
Essentially, because they manage investor money at lower costs, index funds can increase the investor’s after-tax, net returns.