Sometimes, seemingly small actions can shape big outcomes. Take, for example, a nondescript key that could have prevented the Titanic’s tragic end. Leading up to the ship’s ill-fated maiden voyage, British merchant seaman David Blair participated in advance sea trials; but a few days before the Titanic set sail, Blair was replaced by Henry Wilde, a more seasoned officer. In a rush to leave, Blair forgot to hand over the key to the crow’s nest locker, where the ship’s lookout binoculars were stored.
During an official inquiry about the tragic accident, lookout and survivor Fred Fleet stressed how the binoculars would have helped the crew spot the iceberg sooner. Fleet was pressed on how much sooner. “Enough to get out of the way,” Fleet maintained.
This cautionary tale can be applied to a variety of scenarios, beyond crisis prevention. In investing, for instance, small portfolio adjustments, such as tax-loss harvesting and portfolio rebalancing, can potentially lead to big outcomes in the following years. Here’s what investors need to remember about portfolio rebalancing and tax-loss harvesting:
— Tax-loss harvesting and the wash-sale rule.
— Impact of tax-loss harvesting on portfolios.
— Impact of portfolio rebalancing on returns.
— How to rebalance an investment portfolio.
— Rebalancing tips for tax efficiency.
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Tax-Loss Harvesting and the Wash-Sale Rule
When there’s chop in the market, like in 2022, it’s hard to see better conditions around the bend. That’s when tax-loss harvesting really shines because it can help investors extract some positive outcomes from unwelcoming market conditions. This strategy is sometimes called the “lemonade approach.”
Here’s how it works: Let’s say Jane decides to sell an underperforming investment, like an exchange-traded fund or an individual stock, in a taxable investment account. Any realized loss can be used to reduce Jane’s realized capital gains and potentially offset up to $3,000 in ordinary income. The deadline for realized, reportable gains and losses is Dec. 31 of each year.
Next, Jane can reinvest the proceeds into a different investment that is better aligned with her financial objectives. The key guardrail Jane needs to keep in mind for this strategy is the “wash-sale rule.” To avoid running afoul of the wash-sale rule, Jane must not sell a security at a loss and buy the same or substantially similar security within 30 calendar days before or after the sale.
Impact of Tax-Loss Harvesting on Portfolios
It’s hard to fully quantify how many investors take advantage of this lemonade approach in any given year, but there are ongoing reports that attempt to measure its impact on investors’ financial plans over time. For example, Vanguard’s “Tax-Loss Harvesting: A Portfolio and Wealth Planning Perspective” white paper reveals that from 2000 through 2019, tax-loss harvesting helped many investors earn an average annual benefit of 0.95%.
A different study by the Massachusetts Institute of Technology covering 92 years, from 1926 to 2018, found that tax-loss harvesting provided some investors an average benefit of 1.1%.
Impact of Portfolio Rebalancing on Returns
Portfolio rebalancing is another low-key strategy that can help investors move the needle over time. In fact, Russell Investments’ 2024 “Value of an Advisor” study revealed portfolio rebalancing can help investors reduce their portfolio volatility by as much as 1.2% over time. When portfolios have less risk, or volatility, investors are less likely to bail on an investment strategy when the market turns sour.
Chris Tidmore, senior manager in Vanguard’s Investment Advisory Research Center, says, “Rebalancing is generally a risk-mitigation strategy, as a portfolio that is not rebalanced will eventually own more of the higher-returning/higher-volatility assets and therefore end up with more volatility than the initial portfolio. (In a stock/bond portfolio, this is usually stocks).”
How to Rebalance an Investment Portfolio
There are two common approaches to portfolio rebalancing:
Percentage-Based Approach
Let’s say John and his financial planner have determined that a 60/40 mix of equities to fixed income is a good fit for his long-term financial goals. Within a reasonable parameter or disparity, like plus or minus 5%, the percentage-based approach would recalibrate back to the original 60/40 allocation across various asset classes when they are out of alignment.
Time-Based Approach
What if John prefers to schedule adjustments to his investments around calendar events, like his employer’s benefits fair in November, or his annual bonus in December? John prefers to revisit his 401(k) contributions and beneficiary designations around the same time, too. The time-based approach would allow John to establish an annual portfolio rebalance to a 60/40 investment mix on his preferred date.
Rebalancing Tips for Tax Efficiency
Vanguard’s Tidmore adds, “To rebalance in the most tax-efficient way, investors should try to rebalance in tax-deferred accounts, if available and appropriate. Investors can also lower the tax drag of rebalancing by an ongoing tax-loss harvesting strategy or utilize direct indexing as a strategy, which can lower the tax burden of rebalancing over time.”
There’s an opportunity cost at stake for holding too much cash on the sidelines, too. As of Sept. 12, the Federal Reserve Bank of St. Louis estimated money-market balances in the U.S. exceed $6.5 trillion. Since the Fed jump-started rate cuts in September, Tidmore suggests that fixed-income investments are worth a second look: “To the extent that investors have cash investments that go beyond their near-term liquidity needs or rainy-day funds, they may want to consider putting that cash to work and minimize their reinvestment risk by extending their duration and locking in more durable yields; core bond funds or ETFs can be straightforward solutions to accomplish this.” He adds, “Intermediate- and long-term bonds have the added potential for price appreciation as yields fall, as bond prices move in the opposite direction as yields.”
That’s especially good news for long-term investors who want to retire in the next five to 10 years, and for current retirees who need a steady stream of competitive income.
It also signals to investors who need an estimated long-term return of, say, 6% to 7% that the generally less volatile side of their portfolios, bonds, can potentially do a lot of the heavy lifting they’ll need in the coming years to keep their financial plan on track.
In the meantime, well-planned steps, like tax-loss harvesting and portfolio rebalancing, can help investors home in on tax efficiencies and prevent investment drift along the way.
More from U.S. News
8 Smart Tax Strategies for Investors
8 Ways to Minimize Taxes in a Taxable Investment Account
10 of the Best Stocks to Buy for 2024
Portfolio Rebalancing and Tax-Loss Harvesting Tips for Q4 originally appeared on usnews.com
