5 Dos and Don’ts for Your Year-End Portfolio Checkup

December 2, 2014 Updated: December 2, 2014

Video Transcript

Jason Stipp: I’m Jason Stipp for Morningstar. As we’re approaching the end of 2014, investors are trying to squeeze in their portfolio checkups amid all their other plans. Here to help with a list of dos and don’ts is Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: You have a list of a few things investors should keep in mind as they’re doing those checkups here at the end of 2014. The first is to really look at whether rebalancing is in order for your portfolio.

Benz: That’s right. One thing that we see when we look at the data on rebalancing is that it tends to take risk out of your portfolio. So, by systematically pulling back on those asset classes that have performed really well for you and are presumably a little bit richly valued and then steering those monies into the underperforming, perhaps less richly valued, asset classes, you can improve your portfolio’s risk profile.

So, I think it is a great time to think about doing that rebalancing. Of course, it generally makes sense to start with any tax-sheltered accounts where you can move things around to your heart’s content without incurring tax costs. But assuming that you are going to be doing some rebalancing within your taxable portfolio, you can also perhaps be a little bit pre-emptive in terms of managing your tax hit.

So, if you’re going to be selling something and realizing capital gains on which you’ll owe taxes, you may be able to find some losing holdings in your portfolio that you can sell, realize the tax loss, and use that tax loss to offset your capital gains burden.

Stipp: So, do take a look at rebalancing, but you say don’t do a rush job on this. And there are a couple of reasons why you might not want to speed through this, depending on the kind of investor you are.

Benz: I think the key reason is that you do want to be deliberate about it. You don’t want to put the tax cart before the horse. You want to let investment considerations really drive what you’re doing. So, spend some time. I think our X-ray tool is an invaluable tool for helping you figure out where you might want to tinker with your portfolio and make these changes.

If you don’t have time to give due attention to that process, it’s not going to be the end of the world if you have to wait until early 2015. And I would say the other thing is that one of the merits of doing it before year-end is that you may be able to identify these tax losses. For a lot of investors, realistically, especially if they are holders of diversified mutual funds, they may not have that many losses in their portfolios that they can, in fact, use to offset those capital gains.

There are a couple of categories of individuals, though, who may be able to identify those tax losses. For one thing, the holders of individual stocks may be able to surgically find some holdings that are selling below their purchase price. I recently ran a screen and found something like 6,000 individual names, individual stocks, in our database that currently have a one-year loss.

So, you are more likely to find some of those losing holdings if you are an individual stockholder, and also if you are a person who uses that specific share identification method of calculating cost basis. You may be able to surgically prune some positions, some specific lots, that you bought at a higher price than where they are currently trading.

Stipp: With respect to rebalancing, you say that investors should take a look at their major asset-allocation exposures.

Benz: That’s right. Really, when we think about the main purpose of rebalancing, it’s risk control and the main way that you can address the risk/reward characteristics of your portfolio is by making changes to your major asset-class exposures. For a lot of investors who have been very hands-off with their portfolios–maybe they’ve been enjoying this rally that we’ve been in the midst of–if they hadn’t made any changes to, say, a 50% equity/50% bond portfolio that had that positioning five years ago, they would be over 60% equities today. So, it’s a good time to get in and see if you do, in fact, need to steer money away from equities, which have generally outperformed bonds, and move some money into the safer parts of your portfolio.

Stipp: Broad asset-class exposure is going to be a big driver of your portfolio’s returns, but don’t ignore the intra-asset-class exposures that you have.

Benz: That’s right. For a lot of investors, even if their overall U.S. equity exposure is above their target level, they may, in fact, find that when they look at their international exposure, it’s well below their target level. I think that for a lot of investors that repositioning can be valuable, especially because when we look at international stocks, especially developed-European equities, one thing we see is that that is a potential pocket of opportunity in the market today. So, investors could potentially think about doing a little bit of maneuvering there.

Large-cap value stocks, when we look at the price/fair values for stocks that are in that style-box square, those appear to be relatively attractive–certainly, relative to mid- and small-cap growth stocks currently. So, investors should take a look at how the contents of their exposures within their asset classes have perhaps shifted around over the past few years.

Stipp: They may see some even bigger divergences if they haven’t rebalanced for a while.

Benz: That’s right. So, I do think that the rebalancing interval will make a difference here. So, investors who have rebalanced recently may have found that, well, if they stripped back their small-cap exposure–and small caps have dropped a little bit so far this year–that that may, in fact, be an area that needs topping up for investors who have not made changes to their equity exposures. When you look at small-cap performance over the past five years, it’s still ahead of large. So, pay attention to your own rebalancing intervals; that will drive what you do as we head into this rebalancing season.

Stipp: Number three on the to-do list is to make sure you get those funds in your company retirement plan by year-end.

Benz: That’s right. Dec. 31 is your deadline for funding a company retirement plan whether it’s a 401(k), 403(b), or 457. You don’t want to wait until the waning days of 2014 to get in your full contributions. If you are in a position to fully fund your company retirement plan, you want to check in with your HR department, with your payroll department. You should be able to see this on your payroll stub–how much you’ve contributed to that plan, year to date.

Also, remember, if you’re age 50 and beyond, you’re able to make those catch-up contributions and you’re able to start making them in the year in which you turn 50. So, see if you are on track to make that full catch-up contribution as well as the baseline contribution for 2014.

Stipp: But don’t forget your IRA and Roth IRA, even though you have a little bit longer to fund those accounts.

Benz: Right. Your tax-filing deadline will be your deadline for your IRA and your health savings account, but you don’t want to wait for the last minute because you probably will be grappling with your taxes at that time. You want to give some consideration to the right vehicles to steer your money to, specifically for your IRA. So, you want to spend some time thinking about where your portfolio might have holes, where you can strategically deploy those assets so that you’re bringing your total portfolio in line.

Stipp: Number four on the to-do list, a very important one, don’t forget to take those RMDs.

Benz: Right. Required minimum distributions, anyone who has money in a Traditional IRA or a traditional 401(k) or a traditional company retirement plan is going to have to take those required minimum distributions by year-end once their age 70 1/2 and older. So, here again, you don’t want to wait until the very last minute. There is a penalty for missing an RMD. Even though you may be able to [circumvent the penalty by arguing that you didn’t miss it as the result of] any ill intentions, the penalty is 50% on the amount that you should have taken but did not take plus your income taxes on that distribution. So, you don’t want to miss those RMDs.

Stipp: But don’t feel like you have to spend those RMDs, if you don’t need them.

Benz: That’s right. This is often a point of confusion. People look at those RMD tables, especially older retirees, and say, “Hang on a minute–this RMD is taking me way over my planned distribution rate.” So, it’s important to remember that if you don’t need that money for your living expenses, you can reinvest it. Anyone can reinvest the money in a taxable account. If you or your spouse has some form of earned income, you can plow that money into a Roth IRA, as long as your earned income covers the contribution amount.

So, you do have a few avenues for those RMDs to get them back into the market and working on your behalf.

Stipp: Number five on the to-do list is a big one for mutual fund investors: Be on the lookout for potential capital gains distributions from your mutual funds. In some cases, they could be pretty high.

Benz: That’s right, and I know our funds team has been monitoring this issue closely. Check your fund companies’ websites to see if they’ve put out some preliminary capital gains estimates. They should have an estimate of how much they’ll be distributing, as well as an anticipated date for that distribution. So, pay attention to that. You may not be able to do anything about it, but you may be able to find losing holdings in your portfolio that you can use to offset those capital gains distributions.

Stipp: And some investors may want to try to pre-emptively dodge those capital gains distributions, but they can end up costing themselves even more if they don’t pay attention to their own capital gains rates.

Benz: That’s right. So, investors can pay capital gains taxes on mutual funds in a few different ways. One is if the fund itself makes a distribution, and this can happen regardless of whether you yourself have sold any shares in that fund; you will be on the hook for capital gains taxes that way. But the problem with pre-emptively selling to avoid that distribution is that you can trigger your own capital gains tax on the sale.

So, if the security, if the fund is selling at a price above your purchase price, you will trigger your own capital gains taxes, which in some cases could be higher than the amount of the distribution. So, this pre-emptive selling, even though it might seem like a good idea–and certainly may be a good idea if it was something you planned to sell anyway for fundamental reasons–generally isn’t a great idea for most investors.

Stipp: A great list of dos and don’ts for investors at the end of 2014. Christine, thanks for joining me.

Benz: Jason, great to be here.

Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.

*Image of “investment” via Shutterstock