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Portfolio Rebalancing and Tax Harvesting. What Are They?

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Successful investing requires a long-term view and a certain amount of discipline. As an educated investor, you and your advisor work to build your portfolio by allocating investments across different asset classes, including stocks, bonds, cash, and alternatives based on your risk tolerance and financial needs. Diversification across asset classes can help lower volatility while increasing the probability of long-term growth since your money is not tied to the performance of a single asset class. However, in a diversified portfolio, movement in the market will eventually cause one or more asset classes to grow more quickly than others, creating a divergence away from the originally intended allocation. Rebalancing helps keep the targeted allocations in place so that an investor can stay on a strategized path toward long-term financial goals. In simple terms, rebalancing means adjusting your portfolio back to its original asset allocation.

So how often should an investor rebalance? Every investor has a different set of circumstances, so there is no golden rule. However, it probably makes sense to review your portfolio with your advisor on a quarterly or semi-annual basis. Some investors set up a regular rebalancing schedule (monthly, quarterly, or annually) and then decide to rebalance more frequently if their portfolio has drifted away from their allocation goals by a certain percentage, say 5%, 10%, or 15%. Others act regardless of time if their threshold target has been reached. It is important to mention that rebalancing strategies should not be approached in a piecemeal fashion. You want to consider your overall portfolio, not just your retirement accounts, college savings accounts, or taxable brokerage accounts.

There are many ways to get your investments to work harder for you, including better diversification, risk management, and the proper mix of asset classes for your risk level. There is an additional strategy often used to improve portfolio efficiency. This strategy uses investment losses to improve after-tax returns through a method known as tax loss harvesting. At its most basic level, tax loss harvesting is the process of selling a holding in a portfolio that has experienced a loss and then buying a correlated asset that provides similar exposure to replace it. The strategy allows investors to harvest a valuable loss while keeping the portfolio balanced at the desired allocation.

There are some caveats worth mentioning. First, this strategy only works for taxable accounts. Sales in retirement accounts, such as 401(k)s and IRAs, do not generate taxable events and those losses cannot be harvested. Second, the strategy results in a deduction, not a credit. It can only reduce your tax bill to $0, and will not put money in your pocket in the same way that a tax credit can. Finally, it is vital that you do not simply sell and repurchase the same or a substantially identical investment within a certain number of days, as this could be considered a wash sale and negates the benefit of the sale.

As we near the end of the year, tax planning is top of mind for most investors. If you believe that your portfolio could benefit from rebalancing or tax harvesting, we’re happy to answer any of your questions.

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