Year-end Planning

Advisors: Strike right portfolio balance before the new year

Andrew Osterland, Special to
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Chad Norfolk, certified financial planner and senior adviser at FAI Wealth Management, is expecting some difficult conversations about portfolio rebalancing with clients over the next two months.

Given the strong stock market this year, many of his clients have accumulated equity positions outside their desired asset allocations and now face the difficult decision of paring back their stock investments and putting the money to work elsewhere.

"It could be really hard for people to do this year," Norfolk said. "Stocks have done great against just about every other asset class. But it's part of the discipline you need in investing."

Mustering the discipline to sell winners and buy losers may seem all the harder given the still-bleak outlook for fixed income investments in a rising interest rate environment.

"Selling high and buying low goes against human nature," said Barry Glassman, president of Glassman Wealth Services. "Whether it is worries about taxes, sentimentality or just inertia, selling something that's done well for you is difficult."

(Read more: It's time for investors to rebalance portfolios)

Glassman said he asks clients who find it particularly painful just one question: "If you had a million in cash today, are these the assets you would buy?"

"If not, you have to have a rationale for not selling some of them," he added. "Holding on to an investment is a decision to buy it every day."

If you're putting off, or stressing out about, rebalancing your portfolio, advisors suggest keeping a few things in mind:

Diversification is good. The value of a diversified portfolio of assets is that it has been shown, over time, to compound wealth for investors and reduce volatility. "The general principle is that you have to believe in a diversified portfolio," said Norfolk at FAI Wealth Management. If investors have set themselves a traditional 60/40 stocks-to-bonds allocation ratio, they have stick to their plan, he added. "The objective is to get back to your starting point and maintain that diversification level."

Holding on to an investment is a decision to buy it every day.
Barry Glassman
President, Glassman Wealth Services

That doesn't mean you have to sell your appreciated stocks and buy U.S. bonds. The "buy" half of the rebalancing equation is a separate issue and investors can change their fixed income allocation to reflect market conditions.

Norfolk, for example, is putting more money from client equity sales into cash, hard assets (e.g., real estate, natural resources, gold and silver) and a tactical bucket of managed futures and "go-anywhere" mutual funds, along with bonds. (Go-anywhere mutual funds invest in various asset classes and worldwide markets.) He is also reducing the duration of his clients' fixed income allocations and avoiding Treasury bonds.

(Read more: Financial advisor tips for year-end planning)

Rebalancing frequency. For the majority of Americans who have their investments in tax-deferred 401(k) plans or individual retirement accounts (IRAs), the frequency of rebalancing is not an issue. There are typically no transaction costs to do so and most plans have an automatic rebalancing function on a monthly, quarterly or other basis, which Glassman suggests investors take advantage of.

For those with investments in taxable accounts, however, the transaction costs of rebalancing should be kept in mind. A 2010 study by Vanguard Group determined there was no meaningful difference in risk-adjusted returns for portfolios rebalanced on a monthly, quarterly or annual basis. That being the case, an annual or semiannual rebalance will keep transaction costs down.

Mind the taxes. Taxes shouldn't drive your rebalancing decisions, but wealthier investors with significant investments in taxable accounts should keep their potential tax liabilities in mind. Capital gains from selling appreciated stocks can push taxpayers into a higher tax bracket. For people with more than $400,000 in income, the capital gains tax rate jumps to 20 percent, up from 15 percent, this year.

(Read more: Key tips that can minimize the tax bite)

One solution is to delay rebalancing transactions until after year-end if they have a meaningful impact on your tax bill this year. Another is to find potential tax losses in your portfolio that can offset gains on a dollar-to-dollar basis. At year-end, financial advisors comb their clients' portfolios for tax-loss harvesting opportunities for that purpose. With the strong stock market, however, they're getting harder to find. "The problem is that not a lot of people have losses they can use anymore," Glassman said.

Beware of your mutual funds. The run in stock prices is also going to result in some significant capital gains distributions from mutual funds this year. "There are going to be some distributions that shock investors," said Glassman. Check fund family websites for announcements of distributions that funds will typically make in December, and determine if there are ways to manage, avoid or offset the taxable gains. "The goal is not to pay zero taxes but to avoid being surprised and to know what you can do about it," Glassman noted.

(Watch: CNBC explains tax deductions)

Diversify location. Investors with multiple investment accounts should also consider the location of their assets—and the tax implications thereof. Investments that generate a lot of income (e.g., bonds or mutual funds with high turnover) are better kept in tax-deferred IRAs or 410(k)s. Assets that generate longer-term and potentially larger capital gains are better in after-tax Roth IRAs or taxable accounts.

"If you can get 20 to 40 basis points every year, it can add up to large returns in the long run," Norfolk said.

—By Andrew Osterland, Special to