Portfolio Shuffling? Start Here
The stock market has many people’s attention again, thanks to its hot streak since October.
The average U.S. stock mutual fund is up about 8% year to date, and half of that return has been earned just in the last four weeks. Some broad market indexes, including the New York Stock Exchange composite, hit all-time highs last week.
If that has you thinking about buying or selling funds or individual stocks, there are some special considerations at this time of year. There may be opportunities to cut your income tax bill for 2005 while making smart portfolio diversification shifts. But you also could cost yourself money with ill-timed investment moves.
Here are some tips if you’re looking to make changes in your portfolio:
* Watch out for mutual fund capital gains payments. December is when many funds pay out their net realized capital gains for the year. Federal law requires them to do so. The problem for investors: If you buy a fund shortly before that annual payment, you could be buying an instant tax liability.
This isn’t a concern if you’re buying via a tax-sheltered account, such as 401(k) plan or Individual Retirement Account. But if you’re investing through a taxable account, read on.
Say you buy shares of Fund X just before it declares a capital gains payment of $1 a share Dec. 15. That capital gain will count as income on your 2005 tax return, even though you didn’t own the fund for 11 1/2 months of this year.
Unfair? Sure, but that’s how it goes. So if you’re thinking about buying a fund this month -- especially a fund that has soared this year, as in sectors such as natural resources, gold and mid-sized stocks -- it generally makes sense to do so after any capital gains payment, says Christine Benz, an analyst at investment research firm Morningstar Inc. in Chicago.
Many fund companies list their capital gains payout schedules on their websites. The key date is the “record” or “ex” date rather than the actual payment date. Not all funds will make payments this year, but many will.
The risk in waiting to buy, of course, is that the hot market could get hotter, so you could end up paying a higher share price. But the bigger the amount you’re investing, the better off you’d probably be in waiting until after any capital gain is paid, Benz said.
* Selling a fund to take profits or invest in a better idea? Capital gains payments may be less of a consideration than if you’re buying, but still something to think about. If you were going to sell by year-end in any case, you might want to speed up your sale.
Investors typically have fund capital gains payments automatically reinvested in new shares. If you sell before the payment record date, your accounting may be simplified and your overall tax bill may be lower than if you sell after the gains are paid.
Why? Fund companies often pay out both short-term and long-term net gains each December. Those gains now are embedded in your share price.
If you sell the entire fund before any gains payment, the entire profit could be taxed at the long-term capital gains rate (a maximum of 15%), if you’ve held the shares more than a year.
By contrast, if you wait for the payments you could have some gains taxed at the 15% rate and others taxed at your ordinary income rate, which is most likely much higher than 15%.
Again, this is potentially more important the larger the amount of money involved, and the larger any gains payment that is expected this month. And if the market keeps rising, it could be more lucrative to wait to sell.
But “if you expected to sell anyway this year, I think it makes sense to do so preemptively,” before any gains payment, Benz said. As with fund purchases, this isn’t a concern in retirement accounts.
* Be prepared for mutual fund accounting issues. Accounting on your tax return for fund sales can be absolutely mind-numbing if you’ve owned the fund for many years and have been reinvesting capital gains and dividends.
If you have a tax advisor, he or she should know how best to deal with the issue of “cost basis” -- figuring just how much of a gain, or loss, you have on a fund. Hopefully, your fund company will provide you with average cost-basis data, which can somewhat simplify the accounting process.
If you’re doing this on your own, read Internal Revenue Service Publication 564 (“Mutual Fund Distributions”). You can get it at www.irs.gov.
* Be careful about judging your portfolio’s mutual fund winners and losers. Many people like to sell investment losers at year’s end to offset realized gains on their winners, and thereby limit their tax hit. That makes sense.
But “loser” can be a relative term. Say a fund has declined in value since you bought it earlier this year. Should it be sold simply to harvest tax losses that can offset capital gains?
There are two issues to consider. One is why you bought the fund in the first place. If it was a long-term diversification move for your portfolio, selling might make little sense.
Second, even if the fund is down, if it’s down much less than the average fund in its investment category, it might not be the loser you think it is.
Likewise, a winning fund should be judged against its average peer. One place to find fund average returns by investment category is Morningstar’s website, at www.morningstar.com. Click on “funds” on the menu bar that runs across the top of the page.
* Beware the “wash sale” rule. If you sell a fund or individual stock to record a tax loss this year, remember that you can’t repurchase the same fund or stock for 30 days. If you do, the IRS will disallow the tax loss.
* Consider all of your year-end moves in the context of portfolio diversification. “Rebalancing” a portfolio means selling some portion of your investments that have performed well over the last year or longer and using the proceeds to buy into market sectors that have performed less well, or downright poorly.
The idea is to sell high and buy low. Admittedly, this goes against human nature: Many people want to hold on to what’s doing well and avoid the laggards.
But as technology-stock investors learned in 2000, sometimes it’s better to pare back a winner, particularly if an investment has grown to be an overly large chunk of your portfolio.
Likewise, it’s often wise to swallow hard and buy out-of-favor market sectors, says Roy Weitz, who runs Fundalarm.com, a fund watchdog website. “How often it is we see that things look hopeless [for a sector], and then next year it’s on top,” Weitz said.
(The sector that has been most out of favor for the last five years, but finally is showing signs of a turnaround this year, is the large-capitalization growth stock sector.)
If you have a 401(k) or similar retirement savings plan, this is a great time to look over all of the plan’s options and consider whether you have a good investment mix for your level of risk tolerance. Often, rather than trying to guess which investment will be the best performer in the new year, the smarter move is to simply have your money spread around evenly. At a minimum, that means large stocks, smaller stocks, foreign issues and bonds.
Even the most basic diversification plan can save an investor enormous heartache in the long run. It’s tragic that so many people have to learn this the hard way -- by keeping too much of their money in one place for too long.
Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: www.latimes.com/petruno.
