Continuing our discussion of risk management in the July issue of Financial Planning for An Abundant Lifestyle, let’s delve into one of the critical components of your financial picture – your investment portfolio. There are likely some hidden and not-so-hidden risks in your portfolio, and how you choose to address them can make a significant difference in your financial future. Let’s consider some potential perils in your portfolio.
Potential Perils in Your Portfolio
Concentration risk
Among the most recognized risks in investment portfolios is concentration risk, or the lack of diversification. A well-diversified portfolio can usually weather the volatility in a single holding or even in a whole sector or category of holdings. This is because other investments in the portfolio likely would not move in the same direction or to the same degree at the same time. This diversity in investments allows the effects of each individual holding to lessen the effects of the other holdings. Keep in mind, though, that this happens with a well-diversified portfolio, meaning that the mix of assets is chosen specifically because they aren’t correlated, or in other words, they don’t move in the same direction at the same time and to the same degree.
Constructing your portfolio with a plan and a desired outcome is important to address potential concentration risk. When you have a plan for your portfolio, you can more easily recognize when a particular investment has grown to exceed its target allocation. This gives you the opportunity to rebalance your portfolio on a regular basis, selling some positions and purchasing others to bring the overall portfolio back into alignment with your plan.
Embedded gains
If you have held a stock for a long time and it has performed well, you may see that the position is now comprised primarily of capital gain. While it’s great that your investment has performed well, it also means that much of the amount you receive upon selling the stock or other holding will be taxable. Depending on the purpose of the portfolio and the reason for the ultimate sale, you may need to sell more than expected simply to cover the income taxes associated with the capital gain.
One way to handle the risk of embedded gains is to regularly evaluate your portfolio for opportunities to harvest gains. You’ve probably heard of tax loss harvesting, but tax gain harvesting can also be helpful in lowering your overall long-term tax bill. In this case, you would assess your portfolio and your tax situation for the year. If you have investment losses for the year or if you expect a lower income year, you might want to intentionally incur taxable gains by selling an appreciated investment. If you still believe in the stock or other holding, you can buy it back immediately. But, you’ll have generated a tax gain, which your tax loss can offset. You’ll also have a new, increased basis in that stock (or fund) holding because you will have bought it back at a higher price. In the future, when you sell this holding, the taxable gain will be smaller than it would have been without the tax gain harvesting you had already completed. The overarching idea here is that you control when you will take the income – ideally when you are in a lower tax bracket or when you have losses to offset your gains.
Capital Gain Distributions
You may receive taxable capital gain distributions if you hold mutual funds in your taxable portfolio. The Investment Company Act of 1940 requires mutual funds to distribute their ordinary income and capital gains at least once a year. These distributions are generally taxable if the funds are held in a taxable account. The challenge here is that you may receive a capital gain distribution, which is taxable income, even if the value of the investment has decreased over the year. As an example, if stocks in the mutual funds were doing particularly well in February and the fund manager sold some stock for a gain, the fund now has capital gains that it must distribute. But, if the market, or at least the stocks held in the mutual fund, decrease in value during the rest of the year, the value of your holding may have actually decreased during the year, you will still receive a capital gain distribution, and you may owe tax on the distribution.
The potential issue here is that you don’t have control over the timing and amounts of these distributions. Yes, you can sell the fund prior to the distribution of capital gains. However, the sale of the fund itself may incur capital gains. In some cases, if these distributions are unexpectedly high, they can cause an investor to move into the next tax bracket, subject the investor to additional taxes like the Net Investment Income Tax or the Income Related Medicare Adjustment Amount (IRMAA), or potentially cause the loss of valuable tax credits. This frustration is further compounded by the fact that there may be tax due even though the value of the holding has actually decreased during the year.
If you hold mutual funds in a taxable investment account, you will want to be sure that you’re prepared either for the taxes on these distributions or for the taxes on a possible pre-emptive sale of the mutual fund to avoid the distributions. If feasible, you may want to consider switching from mutual funds to exchange-traded funds. However, switching to exchange-traded funds may also require tax planning, especially if there are embedded gains in your mutual fund holdings.