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By Charles Sizemore
| April 17, 2017
I don’t personally do a lot in the way of spring cleaning. It seems that my wife actually takes pleasure in digging through my closet and throwing away clothes that have outlived their usefulness, so I try my best to stay out of her way. But I do usually spend a few hours in the garage and attic going through junk we’ve accumulated over the past year.
What’s good for your household is also generally good for your portfolio. You should regularly tidy up your portfolio and your broader financial plan. You’d be surprised how much “junk” you can accumulate in a brokerage account.
You won’t want to get rid of it any more than you want to get rid of that old moth-eaten Texas Christian University Horned Frogs hoodie you wear during college football season. But frankly, getting rid of it is for your own good. Not only does holding on to portfolio junk tie up capital that can be better allocated elsewhere, it can also be a major distraction.
And frankly, like the moth-eaten hoodie, it’s downright bad for your self respect.
With that in mind, we’re going to look at 10 portfolio spring cleaning tips.
Even though the federal income tax deadline isn’t until April 18 this year, it’s too late sell your portfolio dogs as a write off for your 2016 taxes. You had to get that done by Dec. 31.
But it’s never too early to start planning for next year’s taxes, and now is as good of a time as any.
You shouldn’t sell a stock simply because it has fallen in value. Mr. Market is notoriously fickle, and today’s laggards are often tomorrow’s leaders. But you also have to be honest with yourself. That speculative biotech penny stock you bought on a hot tip that then proceeded to fall by 75% probably isn’t coming back.
You’re better off taking the tax loss and using it to offset any gains elsewhere in your portfolio.
Rebalancing is also an important spring cleaning chore, both among asset classes and among your individual stocks. I agree with the old trader’s maxim to “cut your losses short and let your winners run”.
But if a single stock has come to completely dominate your portfolio, you should probably consider scaling it back a little and reallocating. Otherwise, you run the risk that that single stock will take a wrecking ball to your portfolio should it unexpectedly hit a rough patch.
There is really no hard and fast rule on when a single stock position is too big for a portfolio. My basic rule of thumb is to keep my initial investments to just 3% to 5% of the portfolio. When a stock really has a nice run and starts to make up 10% of the portfolio or more, that’s when I start to scale back.
Every investor is a little different here, and there is no absolute threshold at which you should sell. Just try to be honest with yourself about the risk you’re taking, and do what seems best for you.
As mentioned before, rebalancing a stock portfolio is important.
But arguably far more important is rebalancing among asset classes. Basic financial planning suggests that you should gradually shift out of stocks and into bonds as you get closer to retirement.
Given the strength of the stock market in recent years, it’s likely that your portfolio has become more stock heavy over the last few years. If so, that’s a good problem to have.
But take the time to re-evaluate your overall exposure to the stock market, and if it has been a while since your last rebalancing, you should probably sell down your stock allocation and invest the proceeds in a lower-volatility asset class such as bonds or preferred stock.
Warren Buffett’s first two rules of investing are: 1. Don’t lose money, and 2: Don’t forget rule No. 1.
This is a lighthearted way of saying that risk management is important. Different investors approach risk management in different ways, but all successful investors employ risk management in one way or another.
Personally, I recommend using stop-losses. When you set a stop-loss, you specify a price at which you will automatically sell a stock that is falling. This keeps a small loss from snowballing into large one.
But be careful here, and use stop-losses based on closing prices rather than intraday if possible. This reduces the risk that you could get stuck in a sudden “flash crash” that causes the market to temporarily break down as it did in May 2010 and August 2015.
I love dividends. They allow you to realize a constant return without having to sell shares. That matters relatively little in a raging bull market, but in a sideways market or an outright bear market, it can save you from having to sell at a depressed price.
But while I love dividends, I’m a long way from retirement and I don’t particularly need the cash right now. So, I instructed my broker to automatically reinvest my dividends in new shares. If you are still saving for retirement and don’t need the income right away, I recommend you do the same.
Reinvesting the dividend can turn a slow-moving income stock into a compounding growth machine. And when you do finally retire, you can simply instruct your broker to stop reinvesting the dividends and take them in cash instead.
You can add a lot of value to your portfolio simply by putting your assets in the right account.
For example, bonds are extraordinarily tax inefficient as the coupon payments are taxed as ordinary income. Yet stock index funds held for the long-term are very tax efficient. Other than a modest dividend, which is often taxed at a preferential rate, there are no taxable gains to speak of in most years.
So, the smart move is to place tax inefficient investments like bonds in your IRA or 401k plan and put tax efficient investments like stock index funds in a regular, taxable brokerage account. Doing so will keep your tax bill low, and every dollar you save in taxes is a dollar you can put to work for your investing.
One of the few things the government seems to do right is regularly raise the amount of your salary that you can defer via your 401(k) plan. In 2017, you can contribute up to $18,000, or $24,000 if you’re aged 50 or older, and this doesn’t include employer matching.
If it has been a while since you’ve revisited your contribution limits, chances are good that you can contribute more than you currently are. Apart from the rising contribution limits, you’ve probably gotten a raise or two over the years.
So, log in to your plan and see how much you’re currently contributing, and up the amount if you can. You’ll save money in taxes and turbocharge your retirement savings.
Along the same lines, take this time to see if you are eligible to invest in a Roth IRA. Unlike 401k plans and traditional IRAs, which are required to take minimum distributions once you turn 70 1/2 years old, you can never be forced to take distributions on a Roth IRA in your lifetime.
But unfortunately, not everyone can invest in a Roth IRA. If you are a single taxpayer, your ability to contribute starts to get phased out at income of $118,000 in 2017 and it gets phased out completely at $133,000. For married taxpayers, the phase out starts at combined incomes of $186,000 and gets phased out entirely at $196,000.
The Roth IRA is arguably the single best retirement savings tool ever created. Unfortunately, it’s not available to all taxpayers, so make sure you qualify before writing that check.
I love IRA accounts for their tax savings … and I love master limited partnerships (MLPs) for their consistent income.
But I can’t say I like holding MLPs within an IRA. Doing so can create unnecessary tax complications and, in any event, it is usually a waste of precious IRA dollars as the distributions are often considered tax-free returns of capital. You’d be better off putting a less tax efficient investment in your IRA and holding the MLP shares in a taxable account.
Furthermore, MLPs often generate unrelated business taxable income (UBTI), which can force you to prepare a tax return for your IRA and actually pay taxes at the IRA level.
Having to file a tax return for your IRA isn’t the end of the world, but it’s certainly an unneeded headache you can easily avoid. So do yourself a favor and sell any MLPs you own in an IRA. You can always repurchase them instantly in a regular taxable account.
Finally, use your spring cleaning as a chance to revisit your basic savings goals and assumptions. Are you saving and investing enough to grow a reasonably large retirement nest egg? Be honest here.
The most dangerous thing you can do is to simply procrastinate and avoid asking difficult questions. Because the longer you wait to increase your savings rate, the less time you have for those savings to compound and grow.
If you’re not saving enough, consider some lifestyle changes. Eat at home more, and perhaps even consider cutting your cable bill.
If, by some miracle, you find yourself saving more than you need for retirement … well, good for you! Consider taking your dividends in cold, hard cash and using them to treat yourself to something nice. You deserve it!
This article is from Charles Sizemore of InvestorPlace.