Realizing Gains

It’s been said that the decision to sell is far harder than the decision to buy. This is true and makes all the sense in the world if you consider investing from a purely psychological perspective.

Think about it this way. Investing seems analytical but for most people tends to be highly emotional. Deciding to buy might make you nervous, anxious, maybe even a bit queasy, but it’s ultimately an optimistic act. Being optimistic feels good and typically comes at a time when others are optimistic and buying too, so it’s also easy to feel validated. In short, buying is usually a positive experience once you’ve made the decision.

Selling is ideally the opposite and that’s a big part of why it’s so hard. If you’re doing it right, or at least with any kind of discipline, you’re trimming back investments that are growing well, maybe even market darlings that have been generating big returns. You can get attached to these investments and start resetting your expectations. Think about what ABC stock can do in another year or two? How could I even contemplate of selling? Maybe I should buy more?

This kind of thinking can lead folks to load up on one or a few stocks, often bought at ever-higher prices. Then when markets turn as they always do because they’re cyclical, these same investors often won’t sell, preferring to ride it out and hope for the best. Yes, they could get lucky and be paid for their persistence, but the opposite is also possible. Which do you think is more likely?

Instead of guessing, try to never let things get that far. Traditional asset allocation and rebalancing is pretty boring, but it works well over time because it’s a process to follow that mostly bypasses the problems posed by investor psychology. An optimal mix is created, target weightings are set for each investment, and they’re allowed to float a bit around those weightings. Then the investments are trimmed as they grow too much or added to if they don’t. Investments are swapped out as needed but this isn’t often. Again, boring but effective.

But how do we make the rebalancing part of the process appealing so more people can break the yoke of investor psychology? We can start by trying to make gains real. This is a play on the tax-term of realizing gains, when you switch from paper profits to something that’s taxable. I’ve always been enamored with the term, as only a financial planner can be, because of how it helps make the process more accessible. In other words, realizing gains and giving them a purpose beyond mechanistic rebalancing; making the intangible more tangible.

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I mention all this because we’ve seen a dramatic rise in the stock market from the pandemic lows of early 2020. Year-to-date the S&P 500 is up about 18%, about 30% in the past 12 months, and maybe 60+% from late-March last year. Some parts of the market have done worse while others have done far better. In short, your portfolio likely needs some rebalancing and if you can find a way to make those gains real, so much the better.

Traditionally, when you trim investments back to target weightings you look for other investments in your mix that are underweight. Maybe that’s another stock or stock fund but in this environment it’s likely to be bond investments. While there’s nothing wrong with adding to bonds right now because they’re a safe store of cash, interest rates on bonds are very low (the 10yr Treasury, a key benchmark, is at about 1.3% as of this writing) so it makes sense to look beyond the traditional.

Here are some ideas.

You could consider paying off your mortgage. Or maybe you refinance and bring some cash to the table to pay down your loan. Either way, you’ll likely come out ahead long-term if you can use money that would otherwise buy bonds at 2% or less to pay off/down debt at 3+%.

If you’ve accumulated any other debt at rates higher than that, probably pay those off first.

If you’re 70.5 or older and charitably inclined and want to trim stocks in your IRA, consider gifting up to $100,000 to charities direct from your account. This won’t be taxable to you and certainly makes the dollars real for the charities. This is referred to as a Qualified Charitable Distribution. (For clarity, you can sell whatever you want within your IRA and pay no tax. It’s only taxable when you take money out.)

Maybe a child or grandchild is heading off to college soon. If so, consider gifting them appreciated stock from your non-retirement account. They can sell it and pay capital gains taxes at their own tax bracket (or maybe their parents’ bracket). Alternatively, you can sell the shares yourself, pay the taxes and gift cash to them.

Consider improving your home. Yes, lots of folks are doing that now, prices are high, and it can be difficult to find a contractor, but the return on dollars invested into your long-term home should at least be on par with dollars invested in the bond market.

There’s lots of potential here, of course, and all the “smart” options have to do with leveraging the difference between cost of debt and the expected return on your invested capital.

Last on the list and not to be a total killjoy, consider doing something special for yourself. Maybe realizing gains from stocks lets you think more optimistically about retiring sooner. Maybe it lets you take that trip you’ve been thinking about. Maybe it’s educating yourself to prepare for your next adventure. Either way, it’s a good opportunity to get some immediate personal benefit from recent gains in the stock market.

Obviously, you’ll want to think about taxes when contemplating any of this. Realizing gains in your non-retirement account is subject to capital gains taxes. Realizing and withdrawing from your retirement account probably means ordinary income tax owed on the whole withdrawal. Both can bite but may not hurt too bad with some planning.

There may also be some creative ways to access cash and pay less in taxes, such as trimming stocks in your retirement account while also selling bonds in your non-retirement account and spending that cash instead. There could be some small losses in bonds, or maybe other investments too, that could help offset any gains you take. Again, do some planning here to see what’s possible.

To be clear, the bond market is doing okay, it’s just that persistent low interest rates beg thinking outside the box. I still add money to bonds frequently and ultimately that may be the best alternative for you. My point is that matching a personal goal or expense to the rebalancing process makes doing the right thing that much easier.

Have questions? Ask me. I can help.

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