By Ken Bloom, J.D., LLM

Now that you have finalized your tax returns and the weather is hopefully turning to spring, it is a very good time to spend a few minutes looking at your portfolio. After a very strong first quarter your portfolio probably needs some “spring cleaning.” From the beginning of the year through March the S&P 500 was up an impressive 10.6 percent. As impressive as that gain was, most domestic stock categories did even better! What this means is that unless you have rebalanced your portfolio, the stock portion of your portfolio is a greater percentage of your total holdings than it was before.

Most investment advisors recommend periodically rebalancing your portfolio. Rebalancing serves a very important purpose by making sure that your portfolio always has the appropriate mixture of stocks and bonds. Rebalancing also helps you avoid a major sin of investing: market timing. Studies have consistently proven that market timing does not work. It is impossible to know when an individual stock, mutual fund or index has reached its peak and more often than not, individuals sell at the wrong time, damaging their returns.

Compounding this problem of selling at the wrong time is that investors don’t know when to reinvest. I have met with countless individuals who sold at the wrong time and sat waiting for the right time to reinvest, but ended up losing in the end.

At a minimum you should rebalance your individual accounts at least once a year if not more frequently. Automatically rebalancing your portfolio eliminates the emotion and the futile attempt to time the market.

If the equity allocation of your portfolio has increased significantly, now would be an appropriate time to reduce the stocks. For example, assume your target allocation is 60% stocks and 40% bonds. However your actual allocation is now 70% stocks and 30% bonds (stocks having increased substantially since your last rebalancing). Because your actual allocation is different than your target allocation you need to reduce your stock portfolio and increase your bond portfolio.

When rebalancing the first step is to determine the appropriate allocation for your given your particular risk tolerance, needs, etc. Review your individual accounts to determine where you need to reduce the stock allocation.

Selling stocks that have appreciated will result in a gain. The tax consequences will depend on your particular tax situation and whether the assets sold were owned in a taxable account or retirement account. It is important to know, in advance, the tax consequences of the gains. Capital gain rates for couples earning less than $250,000 per year ($200,000 for individuals) remain at 15%. If your income exceeds that level the tax results will be greater than in 2012.

Although paying taxes on gains is very distasteful, losing money is even worse. Reducing your position in stocks as part of rebalancing your portfolio will lessen the chance of losing money. This is why professional advisers advocate rebalancing.

If you have a capital loss it may be used to offset the gains realized on the sales. Even if there are no losses to be used capital gains at all tax brackets are taxed at lower rates than ordinary income.

Even though bond yields are at historically low rates, adding bonds holdings makes sense if you are too heavily concentrated in stocks. Interest rates are due to increase at some point but it is impossible to determine when that will happen. Because rising interest rates negatively affect bond prices I would avoid long term bonds and focus more on high quality short and intermediate term bonds.

When rates do eventually increase there will be a drop in the value of the bonds, but the loss should be relatively modest (assuming you own high quality bonds). More importantly, bonds have a proven record of reducing the volatility of owning stocks. Historically the more bonds an investor has owned the less volatile the entire portfolio. For the investor who owns a broad based diversified portfolio the reason to own bonds is as a counter balance to stocks, not for the yields on the bonds. In the past when interest rates have increased, bonds continued their role as a protector of the portfolio from stock market volatility.

I know that it is difficult to sell when markets are reaching new highs, but taking some profits to protect the entire portfolio will reduce your portfolio’s overall risk level. Over the long term the return you will realize will not be impacted, but the volatility will be greatly reduced if you rebalance your portfolio on a regular basis.

Email Ken Bloom at