New Tax Law Makes Portfolio Review More Vital Than Ever
Smart investors usually do a comprehensive portfolio checkup in October or November of each year, to see how they might fine-tune their investments by the year-end tax deadline.
This year there is more reason than ever to take a close look at your portfolio, and sooner rather than later. First, the sweeping changes in federal tax laws in August have the potential to affect virtually all investors, large and small.
Second, the surge in stock market volatility in recent months, and the shift in leadership from big stocks to smaller stocks, may be telling us that more momentous changes lie ahead for the 7-year-old bull market.
Many investors have been comfortably on autopilot for much of this decade, and especially since 1994, as blue-chip stocks have overcome every obstacle to post sensational returns in 1995, ’96 and even so far this year.
It has been so easy to make money simply by buying and holding the market’s best-known stocks (or mutual funds) that financial planners and other money pros worry that many of their clients are mentally less prepared for market turmoil than ever.
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A portfolio review can help you put all of this in perspective and can point up ways to save on taxes, lower your investment risk and steer you toward new investment opportunities.
Where to begin?
* Start with an overview. Is your investment mix as you’d like it? If you set out a few years ago to hold a certain percentage of your assets in stocks, a certain percentage in bonds, etc., you may find that Wall Street’s spectacular gains since 1994 have left you with a bigger share of your assets in stocks--and, specifically, blue-chip stocks--than you would prefer.
The rise of smaller stocks in recent months, while many blue chips have stumbled, has sent some investors scrambling to add smaller stocks to their lineup. But those who follow more disciplined asset-allocation programs would have already dedicated some money to smaller stocks, so that they were in place to benefit when that sector suddenly turned.
A portfolio overview simply entails totaling the value of all of your investments (including retirement accounts), segregating them by asset class (principally big stocks, small stocks, foreign stocks, bonds and cash) and deciding whether the percentages in each make sense for you.
* Ask yourself some tough questions about the amount of risk you truly are comfortable taking. Some people like a lot of diversification in their portfolios, to lower the overall risk of loss from a decline in any one asset type. Other investors may be quite happy to be heavily invested in one or two types, even with the higher risk that entails.
There’s no one correct asset mix--it’s as personal a decision as the type of car you drive.
But financial planners say they see many new clients who think they can take the risk of being almost exclusively invested in U.S. stocks, until the planner points out some historical facts about the stock market--for example, that U.S. blue-chip shares lost 45% of their value in 1973-74.
Could history repeat? Who knows? But as wonderful as the U.S. stock market has been to investors over the last seven years, any reasonable person would have to agree that this can’t go on, uninterrupted, forever. At some point the market overall will decline more sharply than the just-under-10% maximum pullbacks we’ve experienced in the 1990s.
In a raging bull market, it’s easy to imagine yourself stoically weathering a bear market. Once the bear arrives, however, people’s emotions often get the best of them.
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That’s why many financial advisors like to keep 20% to 30% of clients’ assets in bonds or other “buffer” investments--things that are unlikely to go down when the stock market does, or are unlikely to go down as much. “I don’t think we have any client less than 20% in bonds now,” says John Blankinship Jr., financial planner at Blankinship & Foster in Del Mar, Calif.
Some clients, he concedes, don’t like bonds. They find them dull and the returns paltry. A five-year U.S. Treasury note, for example, yields about 6% annually now--while the Dow Jones industrial average is up 22.5% this year alone.
But a 6% guaranteed return, Blankinship notes, probably would look generous indeed should the stock market fall 25%.
He tries to get clients to think in terms of their total portfolio return, not just the returns on individual asset types. Ultimately, it’s that overall return that is key to getting you to your financial goals, Blankinship says.
Asked to explain their investment objectives, many people would instinctively say, “To make as much money as possible!”
In fact, if your goals are typical--to live well, plan for a decent retirement and fund your kids’ educations--your investment objective is not to make as much money as you can (which requires taking a huge risk of loss), but rather to earn a particular target rate of return on your total portfolio, with the least amount of risk that can be taken to get there.
When you are comfortable with the investment mix that you expect to take you where you want to go, the key then is to maintain that mix by rebalancing your portfolio periodically--maybe every one to two years--as market changes alter your investments’ values and change the portfolio’s risk level.
* If you want to sell something to rebalance your portfolio, keep the tax law changes in mind. Uncle Sam in August cut the capital gains tax by the largest amount since the early 1980s. But the new tax law also adds much more complexity to investment decisions. “There’s more homework to do this year,” notes Carol Sibley, a financial planner at Wealth Management in Industry.
There now are three capital gains tax rates: For assets sold before being held 12 months, the tax on any gain is the same as ordinary income tax rates, up to 39.6%. For assets sold after being held 12 to 18 months, the top gains tax rate is 28%. And for assets sold after being held more than 18 months, the top tax rate is 20%.
Thus, long-term investors who are eager to take some of their profits in blue-chip stocks and perhaps invest the proceeds in smaller stocks or another asset type have much more incentive to do so: You’ll surrender just 20% in tax, versus 28% under the old law.
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But suppose you have stocks you’ve held for, say, 14 or 15 months. You’d like to take profits, but you’d also prefer to pay a 20% gains tax, not 28%. Yet if you wait to meet the 18-month holding period, there is the risk your stocks could drop.
There are ways around this. Robert Willens, tax specialist with the brokerage Lehman Bros. in New York, says investors in this situation can buy “put” options on the individual stocks involved, or on broad market indexes. A put gives you the right to sell a stock at a set price by a set date. Although it will cost you money, it’s a form of insurance: You’re protecting your paper gain in case the market moves against you before you can actually sell the stock.
Put-option strategies are likely to be much more popular now, Willens says, because Congress did away with another popular hedging technique known as “shorting against the box,” or borrowing and selling shares of a security you already own (thus locking in any gain on the shares you already own).
* Be smart about offsetting gains and losses for tax purposes. Many investors who decide to take capital gains on winning investments naturally look to sell some losers, too, so that the losses offset the gains on their tax return, limiting the capital gains tax liability.
Ideally, you want to offset short-term gains (which are taxed at higher rates) with short-term losses, and long-term gains with long-term losses.
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Willens and other experts note that if you offset short-term losses with long-term gains, you’re essentially wasting some of the tax benefit of those short-term losses. Applied against ordinary income (up to the maximum permitted $3,000 per year), a dollar in short-term losses can save you as much as 40 cents of tax, versus saving just 20 cents of tax if you take long-term gains and apply them against the losses.
* Be careful not to overestimate your tax liability--or tax benefit--from selling mutual funds. Some investors may be more inclined to take profits now in mutual funds held long-term because the gains tax has been cut. Others may still be reluctant to sell, because they feel that even surrendering 20% of a gain in taxes is too much.
But if you own a fund outside a tax-deferred account, remember that you pay taxes every year on capital gains realized and paid by the fund, even if you reinvest the gains (which most people do).
Thus, when you finally sell the fund, your additional tax liability may be far smaller than what you imagined, unless the fund has had very low investment turnover and thus hasn’t realized much in gains.
Sibley also warns investors to be careful about buying and selling mutual funds the closer we get to November and December--which is when many funds make their annual capital gains payouts. “You have to manage this so you don’t cause further tax issues,” Sibley notes--for example, buying a fund just before it makes its 1997 gains payment, so that you create another tax liability for this year.
Tom Petruno can be reached at tom.petruno@latimes.com
