rebalancing and avoiding capital gains taxes strategy

[Arturo]

Hi all,

i read an article that showed me up a new kind of strategy that i didn't think about before:

http://infolific.com/money-management/e ... balancing/

Rebalancing is a variation on the buy low, sell high theme. When you rebalance, you are, in effect, putting more money in to assets that have performed, in relative terms, worse than other assets. And at the same time, you may be selling off some assets that have performed well relative to other assets. As a buy-and-hold kind of investor, I don't sell any assets to rebalance. Instead, I just buy more of whatever is below my targets. As an added benefit of rebalancing this way, I don't trigger any capital gains because I don't sell anything.

What do you think about this strategy to avoid capital gain taxes when rebalancing in Permanent Portfolio? when you buy, you are adding up savings for compounding return.

thank you very much in advance.

[Pointedstick]

By not selling, you may give up substantial unrealized gains if what's up goes down later, especially with gold. Since gold gives off no interest or dividends, the only way to ever realize a profit on it is to sell. The tax man sucks, but what's even worse is being so afraid of him that you cripple your own investment performance.

[craigr]

It depends how out of whack things are. Generally I advise putting new money into your weakest performing asset. This way you can put off rebalancing for quite some time. However once your portfolio grows enough, or an asset goes on a big run up in price, it may not be possible to put in more money to offset the gains. In that case you may have to sell to rebalance. But if you are smart about how you deposit your money into the portfolio you can put off rebalancing for quite some time.

[MachineGhost]

It seems to me that the strategy you quote will indeed avoid incurring capital gains taxes.

The strategy you are quoting is, in essence, "buy the lagging asset", which lots of people do, and which craig advocates above, and in the book (I think).  For overall returns, however, I doubt that there is any reason to prefer or reject this vs. any other strategy.

I believe sophie looked at this issue and found that buying the lagging assets underperformed other strategies.  Letting a gain go is as criminal as accumulating losses.

[Arturo]

By not selling, you may give up substantial unrealized gains if what's up goes down later, especially with gold. Since gold gives off no interest or dividends, the only way to ever realize a profit on it is to sell. The tax man sucks, but what's even worse is being so afraid of him that you cripple your own investment performance.

Hi Pointedstick,

do we have some kind of study about how much the taxes involved into the 1 or 2 times year rebalance (capital and dividend gains, 15% withholding tax for foreigners, buying&sell fees) impact the long term PP investment performance?

It depends how out of whack things are. Generally I advise putting new money into your weakest performing asset. This way you can put off rebalancing for quite some time. However once your portfolio grows enough, or an asset goes on a big run up in price, it may not be possible to put in more money to offset the gains. In that case you may have to sell to rebalance. But if you are smart about how you deposit your money into the portfolio you can put off rebalancing for quite some time.

Hi Craig,

i was thinking about this strategy (just buying the lagging asset) plus trying to buy iShares ETFs that automatically reinvest the dividends, so you avoid dividends gain taxes. But as i am seeing, the first option is not adviced at all ..

[Pointedstick]

To be clear, I follow the buy-the-lagging-asset strategy like many others, and I've also observed that this reduces the need to rebalance. But I'm not averse to doing it once I hit a 15/35 band.

Arturo, I'm not familiar with the iShares automatic tax-free dividend reinvestment. That sounds very cool! Would you mind providing a link or some more details?

[Xan]

Rebalancing is the way that the PP can be more than the sum of its parts, that is, harvesting volatility is what allows it to exceed the profits of simply holding the four assets.

When I add to mine, I don't wish to delay rebalancing.  I add to each asset in proportion to its current value in the portfolio.  That way, a rebalance happens whenever it happens, decoupled completely from the schedule of my contributions.  I think this is a too-often-ignored method.  Assuming trades are low-cost or free, of course, which depending on the exact funds and broker, they can be.

[blackomen]

Every few months, I contribute funds to my PP and I do something similar..  I'll buy all 4 assets in a way that resets all of my weights to 25%.

I guess it's possible if you're young (like me) or don't have that much saved up.  When you have, say, 50K in the PP and contribute 5K every few months, it's likely the market values between your best performer and your worst performer is less than 5K.

5K is about a 10% fluctuation with respect to your 50K, and with an average salary and modest spending habits, you can easily save that in a few months.

Now let's say you've been saving for a few decades and have 1 million in the PP.

Now, the same 10% fluctuation means $100,000..  unless you're a CEO or something, you're not likely to earn that much money in a few months..  and even if you do, it's likely you've probably saved up far more than 1 million.

In other words, you'd still likely be forced to sell to rebalance your portfolio eventually.

[Arturo]

Every few months, I contribute funds to my PP and I do something similar..  I'll buy all 4 assets in a way that resets all of my weights to 25%.

I guess it's possible if you're young (like me) or don't have that much saved up.  When you have, say, 50K in the PP and contribute 5K every few months, it's likely the market values between your best performer and your worst performer is less than 5K.

5K is about a 10% fluctuation with respect to your 50K, and with an average salary and modest spending habits, you can easily save that in a few months.

Now let's say you've been saving for a few decades and have 1 million in the PP.

Now, the same 10% fluctuation means $100,000..  unless you're a CEO or something, you're not likely to earn that much money in a few months..  and even if you do, it's likely you've probably saved up far more than 1 million.

In other words, you'd still likely be forced to sell to rebalance your portfolio eventually.

You are totally right :-). Is not the same buying 5k than 50k.

I still do not understand why ETFs don't work like funds, and transfers between ETFs are not possible. Its annoying that everytime you want to rebalance, you have to pay sell & buy commissions,  triggers capital gains taxes, etc.

by the way, is there any issue to build up your PP with index funds in stead of ETFs? they allow transfers between ETFs without triggering capital gains taxes, are low cost like ETFs, and Vanguard offers a wide number of them.

[sophie]

I did some simulations (reported elsewhere on the forum) comparing 3 strategies:  saving to the cash component and rebalancing when it hit 35%, buying the lagging asset, and buying all four assets equally (like dollar cost averaging).  I expected the lagging asset strategy to win, but the third strategy actually won.  Saving to cash had the worst performance.  I didn't take taxes into account, but rebalancing was sufficiently infrequent that it probably wouldn't have made a difference.

The smaller your contributions are relative to the size of the PP, the less of a difference this makes.  I ended up following a mix of strategies, just for convenience:  regularly buying no-commission funds with some of the savings, socking the rest into cash and then buying the lagging asset with it every 3 months.

[blackomen]

Also keep in mind that the best time to rebalance by selling is NOW especially if you're young since taxes are at historical lows, you're in a lower income tax bracket, and you don't have that much in the way of capital gains yet.

Unfortunately, it's likely taxes will go up just when you need to sell the most in your later years due to moving to a higher bracket and political pressures to increase taxes over the next few years/decades.