Rebalancing a taxable account using new inflows...

[FIREdreamer]

Hi, I have a question regarding my taxable portfolio and need you all's expert opinions.

I have a taxable account invested in several index funds ranging from large caps to small caps to international... I use new inflows to rebalance the account so that I never have to sell anything (I try to minimize taxes). The question is this: I add money to the account every month and I have a spreadsheet to track asset allocation and to determine what I need to buy each month to bring the asset allocation back to where it should be (so if US stocks did well in the past month and Int'l stocks did not, I buy more Int'l stocks with the new contribution). It dawned on me that this is equivalent to a monthly rebalancing of my portfolio. Now I have heard that rebalancing my portfolio too often could negatively affect my returns.

So the question is: is it OK to continue doing that, or should I try to invest the money regardless of performance and rebalance only once or twice a year (I usually have larger sums of money to invest every 6 months that I could use to rebalance the portfolio).

I give you an example to illustrate what I'm talking about:
Let's say that my ideal asset allocation is as follows: 25% US large caps, 25% US small caps, 25% US mid caps, 25% International (it's just an example).

Right now this is what I do: Let's say Intl and small caps underperformed in the past month. So I might invest my new monthly contribution as follows:
20% US large caps, 30% US small caps, 20 % US mid caps, 30% International.

The question is should I keep doing this or instead invest the monthly contribution as follows: 25% US large caps, 25% US small caps, 25% US mid caps, 25% International (in line with my ideal asset allocation) and rebalance the portfolio only once or twice per year as needed?

[Nords]

Originally Posted by FIREdreamer

It dawned on me that this is equivalent to a monthly rebalancing of my portfolio. Now I have heard that rebalancing my portfolio too often could negatively affect my returns.
So the question is: is it OK to continue doing that, or should I try to invest the money regardless of performance and rebalance only once or twice a year (I usually have larger sums of money to invest every 6 months that I could use to rebalance the portfolio).

I think you're fine. You're value averaging, not rebalancing.

The "negative effects of rebalancing" debate usually centers around paying taxes and timing the market. The conventional wisdom is that you shouldn't do it by the calendar at all-- try to let your winners run and only rebalance when they get way out of whack. You can debate whether it's better to rebalance quarterly and pay short-term cap gains taxes, or annually and pay long-term cap gains taxes. Then there's the seasonality debates of the January effect, the summer slump, the October bottom, the Santa Claus rally... bleagh.

You're not doing that-- you're putting more dollars into the assets that are underperforming, so you're buying more shares on the cheap. Classic value averaging, and quite tax-efficient.

Hypothetically you should make a lump purchase with those larger sums as soon as you get them, since the market will go up about 60-70% of the time and you'll do better by getting the lump sums all in the market earlier. But the real value of periodic purchases is the discipline of the habit, so keep buying as regularly and as frequently as you're comfortable with.

[packrat44]

IMHO you are doing it in a good manner. You are DCA and at the same time you are keeping your asset allocation balanced without incurring taxes usually associated with rebalancing.

[FIREdreamer]

Thanks for your answers. I am glad you guys think I am doing it right. I have been doing it this way for a few years, but after reading an article about rebalancing I suddenly started to wonder whether I was doing the right thing.

Hypothetically you should make a lump purchase with those larger sums as soon as you get them, since the market will go up about 60-70% of the time and you'll do better by getting the lump sums all in the market earlier. But the real value of periodic purchases is the discipline of the habit, so keep buying as regularly and as frequently as you're comfortable with.

I hear you. Money from my paycheck gets transferred automatically to my taxable account on the same day every month and it is usually invested as soon as it gets credited to my account unless the fund I want to purchase is paying a dividend imminently, in which case I wait a few days. The larger sums of money I invest every six months come from bonuses and they get invested as soon as I can transfer the money to my brokerage account.

[chinaco]

I think many of us use Dollar Cost averaging when investing. It makes sense to me to consider using that new money to try to help keep the portfolio at the target allocations.

One thing that i have started doing is having the Mutual Fund Payout (cap gain/div) in the taxable accounts go directly to a MM account rather than reinvest in the funds (all equity funds). That way I can use it to help with the rebalancing effort. But on 401k contributions... they go directly to a specific investment. In my case I have only one decent equity fund option available in my 401k (i.e., low cost index)... the rest are cr@p and over priced. My 401k contribution goes to that equity index fund. In DW case, the 401k contribution goes to a Bond Fund.

Unfortunately we have a patch quilt of stuff in the tax deferred accounts and just do the best we can to make it work for our allocation strategy. So far all of our bonds are in tax deferred accounts. I think we will be able to keep it that way.

[packrat44]

Originally Posted by chinaco

I think many of us use Dollar Cost averaging when investing. It makes sense to me to consider using that new money to try to help keep the portfolio at the target allocations.

One thing that i have started doing is having the Mutual Fund Payout (cap gain/div) in the taxable accounts go directly to a MM account rather than reinvest in the funds (all equity funds). That way I can use it to help with the rebalancing effort. But on 401k contributions... they go directly to a specific investment. In my case I have only one decent equity fund option available in my 401k (i.e., low cost index)... the rest are cr@p and over priced. My 401k contribution goes to that equity index fund. In DW case, the 401k contribution goes to a Bond Fund.

Unfortunately we have a patch quilt of stuff in the tax deferred accounts and just do the best we can to make it work for our allocation strategy. So far all of our bonds are in tax deferred accounts. I think we will be able to keep it that way.

I am in the process of changing to have my capital gains/dividends deposited to my MM account for the same reason as you.

The TSP account was nice when working for the government because they offered a number of low cost options. You could change your allocation every pay period if you were so inclined.

[simple girl]

Originally Posted by FIREdreamer

Hi, I have a question regarding my taxable portfolio and need you all's expert opinions.

I have a taxable account invested in several index funds ranging from large caps to small caps to international... I use new inflows to rebalance the account so that I never have to sell anything (I try to minimize taxes). The question is this: I add money to the account every month and I have a spreadsheet to track asset allocation and to determine what I need to buy each month to bring the asset allocation back to where it should be (so if US stocks did well in the past month and Int'l stocks did not, I buy more Int'l stocks with the new contribution). It dawned on me that this is equivalent to a monthly rebalancing of my portfolio. Now I have heard that rebalancing my portfolio too often could negatively affect my returns.

So the question is: is it OK to continue doing that, or should I try to invest the money regardless of performance and rebalance only once or twice a year (I usually have larger sums of money to invest every 6 months that I could use to rebalance the portfolio).

Your question makes me think twice about how we have been handling our taxable account. We have been keeping only total stock market index (Vanguard) in our taxable account to minimize tax consequences. We regularly contribute to this account plus contribute to our 401K and IRA's (keeping mid caps/small caps/international/bonds in the 401k's/IRA's). Well, lately we have had a significant inflow of cash and have been putting more into the taxable account. As a result, our asset allocation has gotten out of whack.

To remedy this, we have been selling/rebalancing within the 401K's. I am now questioning this strategy. Is it ok to continue this approach or would it be better to start buying some small caps/internat/etc. in the taxable account? Pro's/con's of each strategy?

[kaudrey]

I have a taxable account invested in several index funds ranging from large caps to small caps to international... I use new inflows to rebalance the account so that I never have to sell anything (I try to minimize taxes). The question is this: I add money to the account every month and I have a spreadsheet to track asset allocation and to determine what I need to buy each month to bring the asset allocation back to where it should be (so if US stocks did well in the past month and Int'l stocks did not, I buy more Int'l stocks with the new contribution). It dawned on me that this is equivalent to a monthly rebalancing of my portfolio. Now I have heard that rebalancing my portfolio too often could negatively affect my returns.
-----

FIREDreamer - I do this also. I consider it DCA, not really rebalancing. If my allocations get more out of whack, I generally just move things around in my TSP account, which doesn't cost me anything, or my IRA.

[ats5g]

Originally Posted by simple girl

Your question makes me think twice about how we have been handling our taxable account. We have been keeping only total stock market index (Vanguard) in our taxable account to minimize tax consequences. We regularly contribute to this account plus contribute to our 401K and IRA's (keeping mid caps/small caps/international/bonds in the 401k's/IRA's). Well, lately we have had a significant inflow of cash and have been putting more into the taxable account. As a result, our asset allocation has gotten out of whack.

To remedy this, we have been selling/rebalancing within the 401K's. I am now questioning this strategy. Is it ok to continue this approach or would it be better to start buying some small caps/internat/etc. in the taxable account? Pro's/con's of each strategy?

IMO, you're going things correctly. As you add to the TSM fund in the taxable account, you should be moving money around in your tax-deferred accounts to adjust for the growing TSM fund in the taxable account. For example, as you contribute more and more to the taxable TSM fund, selling some US large caps in the tax-deferred and buying small caps, int'l, bonds, etc.

I think I'd wait to buy some small caps/internat/etc. in the taxable account until they no longer fit in the tax -deferred accounts. For example, if someone is using all their tax-deferred room for bonds, REITs, CCF's, and small value, then if they want US large and Int'l, they're forced to hold them in the taxable account.

hth

[LOL!]

I believe an international fund is reasonably tax efficient, so something like VEU or VFWIX would be just fine for a taxable account. You can also take the foreign tax credit if held in a taxable account. You would not be able to take the FTC if the international fund was in a tax-deferred account.

Since I have switched to ETFs and mostly index funds in my taxable accounts, I am not worried about distributions in December. I do get about the same dividends (1.5% to 2% rate) from the international, emerging markets and small cap funds in my taxable accounts as I do from a total stock market fund. I see no way around getting dividends except for tilting to growth index funds which is something I don't want to do.

I finally realized that a balanced fund in taxable account is a big no-no for me tax-wise, so I trimmed back my Dodge&Cox Balance to just a few hundred dollars.

Anyways, for rebalancing, I do it continuously with any new money I add as well as on worst days in the market.

My tax-deferred accounts hold fixed income, TIPS, REITs, and some equity funds.

[WanderALot]

Originally Posted by ats5g

IMO, you're going things correctly. As you add to the
I think I'd wait to buy some small caps/internat/etc. in the taxable account until they no longer fit in the tax -deferred accounts. For example, if someone is using all their tax-deferred room for bonds, REITs, CCF's, and small value, then if they want US large and Int'l, they're forced to hold them in the taxable account.

I have been buying VG Tax Managed International in my taxable accounts in order to meet my allocation. It does have a redemption charge if redeemed before 5 years, but since I shouldn't be touching this money for a while, I'm not too worried about it. All my tax-deferred accounts are used up with small-cap, bonds and Wellington.

[audreyh1]

I agree - you are not really rebalancing in the traditional sense, you are putting the new money into whichever asset class is underperforming at any given time. This is a very clever way to average in. Personally I can't think of a more optimal way to do it, especially considering the tax efficiency inherent in your approach.

Audrey