Asset Allocation, Rebalancing and Capital Gains

[ChrisL]

We are about five years from retirement with about 80% in equities and 20% in bonds. Although we know that we should be shifting towards bonds, most of the equities are in individual stocks that we have held for decades with a basis value of 10% or less of the market value. Thus, we will incur a large capital gains tax. Is it worth it? If we do start to move towards bonds, how fast should we make this transition?

 

[travelover]

What is your desired AA now and when you retire? Boglish recommendation is your age in bonds, or so.

How much are you contributing to retirement savings now? Can you just funnel all new money to bonds?

 

[Behan]

Assuming you will need to spend that money in the future then you will incur capital gains tax at some point. Who knows what tax rates will be in the future, but if I had to guess I'd say that they won't be going down. Of course you don't have to sell all of those shares at once. But I'd get to your target allocation sooner than later, not because of taxes, but because you'll sleep better.

 

[jIMOh]

I agree putting new monies to bonds helps the rebalance
I would also suggest putting all dividends into a money market account (now) and not reinvesting them

It's better to pay taxes and lock in gains than to take too much risk and lose capital.

 

[LOL!]

If your sustained withdrawal rate from these assets will be 1% or so, then it is probably not worth it. OTOH, if your SWR is 3.5% to 4%, then it will definitely be worth it at some point.

 

[chinaco]

If I were in that situation, I would move as quickly as I could to transition enough money to bonds to secure the FIRE date and income for several years. However, I would consider tax consequences (e.g., AMT) and manage it.



I had some highly appreciated stock (taxable account) after the tech bubble burst. Of course, its value was lower than before the market contraction.... I took that opportunity to sell it over a couple of years to reinvest in mutual funds to avoid AMT.

When we were 5 years from FIRE, I made the move to bonds fairly quickly... however, the shift to bonds was in a tax deferred account (so there was no tax consequence).

 

[lowflyer]

A similar situation happened to an acquaintance of mine. Over literally decades of saving and packing money away, he essentially painted himself into a financial corner. Literally all was invested in stock that now had significant capital gains. This made any attempt at AA painful at best, due to taxes. On the plus side, many of the stocks were utilities, so the portfolio generated a reasonable return from dividends, but not as much as desired.

I'd look seriously at beginning to sell off a little at a time and accept the capital gains up to a point. Although the stocks have appreciated a lot, they can also go back down, so it seems logical to harvest some of those gains. As Behan said, "Who knows what the tax rates will be in the future."

 

[chinaco]

Unless you hold a fairly diversified portfolio of stocks.... and actively manage it... you probably have quite a bit of company risk.

It sounds like you are a buy an hold person. Would you be on top of it enough to trim losses quickly? Do you actively follow the companies and their fundamentals?

Large companies do not go out of business or have protractive down turns (no matter how it happens... fraud, poor management, poor economy, class action law suit, can't compete, etc)

GM
Chrysler
Enron
Lehman Bros
Pick a Bank.
Pick an Airline.
On and On.

I was a buy and hold stock investor... had some successes and some losses. Made more money than lost. But in the end, I was not out performing my VG investments. I made the decision about 10 years ago to use Mutual Funds to better diversify against company risk since the amount of money was significant.

 

[LOL!]

The changing tax laws on capital gains taxes should give one some incentive to figure this all out. If your portfolio is so large that most of these assets will go to your heirs, that is a factor as well.

 

[Ed_The_Gypsy]

It's better to pay taxes and lock in gains than to take too much risk and lose capital.

+1

 

[ChrisL]

Thanks to all

I got a lot of thoughtful replies which helped me to judge my position. It seems to boil down to a question of risk versus return. Do I need to shift to bonds to 'sleep well at night'? No, I sleep fine. My portfolio is well diversified across industries, large and small caps and international/domestic. If I get an opportunity, I may shift somewhat to bonds, but certainly not the 58% that my age would indicate. But I'm not going to pay a lot of taxes just to get to that balance. Thanks again, everyone.

 

[clifp]

I got a lot of thoughtful replies which helped me to judge my position. It seems to boil down to a question of risk versus return. Do I need to shift to bonds to 'sleep well at night'? No, I sleep fine. My portfolio is well diversified across industries, large and small caps and international/domestic. If I get an opportunity, I may shift somewhat to bonds, but certainly not the 58% that my age would indicate. But I'm not going to pay a lot of taxes just to get to that balance. Thanks again, everyone.

If you are comfortable holding that level of stocks and it is well diversified than I wouldn't be in rush to buy bonds. Academic research (modern portfolio theory) showed that efficient frontier (the optimum risk return level) was 75% stocks/25%.

Now much has changed (e.g. the 2008 crash and I think even the dot com bubble) since the research was done, and 75/25% is for a permanent portfolio not one where are withdrawing money. However, for long retirement I suspect the "optimum" is probably closer to your 80/20 allocation than the simple Bogle formula stocks = 100 - Age.

 

[chinaco]

If you are comfortable holding that level of stocks and it is well diversified than I wouldn't be in rush to buy bonds. Academic research (modern portfolio theory) showed that efficient frontier (the optimum risk return level) was 75% stocks/25%.

Now much has changed (e.g. the 2008 crash and I think even the dot com bubble) since the research was done, and 75/25% is for a permanent portfolio not one where are withdrawing money. However, for long retirement I suspect the "optimum" is probably closer to your 80/20 allocation than the simple Bogle formula stocks = 100 - Age.

The challenge is that these models do not perfectly describe a solution to the problem... Human behavior makes it imperfect.


I buy in to MPT and it influences my investment decisions. But it is not a crystal ball.... perhaps a translucent one.


I would suggest th OP develop a good understanding of their situation and the variety of risks that they "may" need to deal with.

Is the goal to grow at a faster rate or to guarantee steady income?? Possibly a couple dozen other trade-offs.

 

[DblDoc]

I would also look for opportunities to tax loss harvest over the next 5 years and use the losses to help cover the gains.

TLH: Tax Loss Harvesting - Bogleheads

After the crash of 07/08 I have a lot of losses squirreled away.

DD

 

[ChrisL]

Tax losses

Good point DblDoc, that was the first thing that I did. After the dotcom and financial bubbles, even a buy and hold investor like me had a few losers. Selling those losers and taking some capital gains enabled us to get to about 20% bonds, but everything else has a basis value below 25% of market value. It's odd that this isn't discussed much in the investment media.

 

[clifp]

The challenge is that these models do not perfectly describe a solution to the problem... Human behavior makes it imperfect.


I buy in to MPT and it influences my investment decisions. But it is not a crystal ball.... perhaps a translucent one.


I would suggest th OP develop a good understanding of their situation and the variety of risks that they "may" need to deal with.

Is the goal to grow at a faster rate or to guarantee steady income?? Possibly a couple dozen other trade-offs.

You're right it is important to set your goals before deciding on the best strategy.

My comment was primarily based on my dislike for bond funds in this environment. At lot of people are understandably concerned about the stock market so have poured money into 'safe' bond funds.

The OP sounded he like was comfortable with a high equity exposure but was feeling pressure from 'conventional wisdom' to increase his bond allocation. Interestingly enough if you substitute CDs for bonds than I personally would suggest trimming back his equity allocation.