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Stock investors are no doubt excited these days. The S&P 500 (.SPX) has more than doubled since its March 2009 low, including a 10% jump this year alone. But there's a cloud in the silver lining: The big gains in stocks may have thrown your investment mix out of kilter.
That makes this a perfect time for a portfolio tune-up. In addition to checking your allocation and rebalancing, you can look for ways to minimize taxes, lower fund costs or make other moves as needed. Or you might just need a gut check to make sure your emotions aren't leading you to bad investment choices.
Here are five things to consider doing now, based on interviews with advisers and investing experts. As always, you should do your own research or consult a financial adviser before making any investment decisions.
With stocks rallying, it may be tempting to let your stock holdings grow into a larger share of your portfolio. But you could regret it if there's a 10% market correction after your portfolio has grown to 75% stocks, for example, from your target of 60% — magnifying your losses.
That's where periodic rebalancing can help. Every six months, you should trim assets that have done well and add to your laggards. Staying disciplined forces you to "buy low and sell high," says Carl Friedrich, an adviser with Piermont Wealth Management in New York. If your target allocation is 60% stocks, for example, and it grows to 65% you could trim it to back to 60% and invest the cash in bonds or other assets in your portfolio that haven't fared as well.
Granted, this may go against your intuition and feel like you're taking money off the table. But the point of rebalancing is to take emotion out of investing and not let your strategy be swayed by the market's herd mentality. Indeed, studies generally show that rebalancing systematically beats a buy-and-hold strategy, offering higher returns and lower volatility over long periods.
Experts differ on whether to rebalance periodically or whenever your mix strays from your target by a certain amount. Friedrich says rebalancing every six months offers similar benefits to adjusting the mix more frequently, and helps keep trading costs down. You should also rebalance your entire portfolio holistically, including your taxable and retirement accounts since they're all part of your pool of assets.
If you're not comfortable going it alone, one option is to use a "balanced" fund for your core portfolio. These funds hold a mix of stocks and bonds, typically around 60% stocks and 40% bonds, and the mix is adjusted by the portfolio manager based on the prices of holdings and other factors.
Balanced funds with strong long-term performance and reasonable fees, according to Morningstar, include James Balanced: Golden Rainbow Fund (GLRBX), American Century Investments Balanced Fund (TWBIX) and Villere Balanced Fund (VILLX). These funds may not be beat a pure stock fund when stocks are rallying, but they tend to have steadier long-term performance and their 10-year average returns range from 7% to 10%.
Taxes have gone up for almost everyone this year, making it more important to manage your portfolio tax-efficiently, says Andrew Feldman, an independent adviser in Chicago.
A classic way to manage your portfolio is to "harvest" tax losses to offset capital gains. If you have some funds that have lost considerable money, you might sell them and rotate into similar funds that look more promising, keeping your investment mix the same.
One caveat: Make sure you don't violate IRS rules on "wash sales," which disallow losses if you buy a security the IRS deems to be "substantially identical" 30 days before or after the sale. Selling an S&P 500 index fund and buying an S&P 500 ETF within 30 days may violate the rules, for instance. You should consult a tax professional if you're uncertain.
Closed-end funds that pay ordinary income are also good candidates for retirement accounts, says Feldman, as are mutual funds that pay lots of short-term capital gains or "non-qualified" dividends, both taxed at ordinary income rates. You can check your fund's distribution history and tax efficiency at sites such as Morningstar.com.
For bond investors in a high tax bracket, it may pay to hold municipal bond funds in a taxable account and high-yield funds in an IRA or other tax-exempt account.
Two bond fund options to consider: In the muni space, Wells Fargo Advantage Intermediate Tax/AMT-Free Fund (SIMBX) earns five stars from Morningstar and returned an average 5% over the last 10 years, beating 96% of rivals. In the taxable-bond world, PIMCO Income Fund (PONDX) also receives five stars from Morningstar. It returned an average 12.2% in the last five years, ahead of 98% of peers. Both funds have downsides, including interest-rate and credit risks.
Keep in mind, minimizing taxes shouldn't be your only consideration. You may rack up trading costs or have to pay capital-gains taxes if you sell a winning investment. And you may want to keep conservative investments like a short-term bond fund in a taxable account as part of an emergency fund.
"I'm always concerned about the perfect storm where the market is down 30% and you lose your job," says Feldman. "You want a less-volatile piece of your portfolio to be accessible for those needs."
High fees are the silent killer of long-term returns: Fund expenses pile up over time, gradually eroding your portfolio value, and many studies indicate that low-cost funds fare better over long periods. Indeed, a 2010 report by Morningstar found that expense ratios are "strong predictors of performance." In every asset class over every time period, the report found, low-cost funds beat high-cost funds on average.
Of course, some high-fee funds may consistently beat the market. But a high-fee fund that tracks its benchmark index probably isn't worth keeping, says Chad Carlson, a financial adviser with Balasa Dinverno Foltz in Itasca, Ill.
For one thing, it's likely to generate lower after-tax returns since it will distribute capital gains in most years. Plus, you can probably find a cheaper alternative with a strong record or switch to a lower-cost ETF that's more tax-efficient.
Even a switch between ETFs may save some money. Carlson, for example, recently swapped clients out of the iShares MSCI EAFE ETF (EFA) and bought the iShares Core MSCI EAFE ETF (IEFA). The ETFs are essentially twins holding the same mix of global stocks, he notes, yet the "core" ETF costs just 0.14% of assets, or $14 for every $1,000 invested, versus 0.34%, or $34, for the former.
Some stock funds with fees below 1% and solid, long-term performance, according to Morningstar, include FMI Large Cap Fund (FMIHX), Janus Triton Fund (JATTX) and Fidelity Focused Stock Fund (FTQGX). Each fund has beaten its category average over the last five years, ranking in the top 10%. The risk: Like any stock investments, they could lose money in a market downturn.
For many years, economists assumed investors behaved rationally, taking into account all available information and making choices in their best financial interest.
But that's not quite the case. Behavioral finance studies that use brain imaging scans and psychological experiments have found that investors tend to be influenced by emotions or other "biases" when making financial choices — often to their own detriment.
One common bias: "loss aversion." According to one 1997 study, the pain people feel from a loss is twice as strong as the pleasure associated from a similar gain. That's why people will generally avoid a 50% chance of losing $100 even if they have a 50% chance of winning $150.
This loss aversion is natural and may be perfectly rational in some situations. In the investing world, though, it may cause some folks to be overly cautious, avoiding risky assets like stocks that they may need for their portfolio's long-term growth, says Dirk Hofschire, a Fidelity Investments senior vice president and co-author of a recent paper on the subject.
"Being averse to losses can translate into irrational behavior when you apply it to investment decisions," he says.
Obsessively watching your investments can be harmful too, not just to your emotional health but to your wealth. If you check your portfolio frequently, you increase the likelihood of seeing losses.
That "mental agony" can make you more fearful, causing you to shun stocks and other riskier assets, says Hofschire. Indeed, a 1997 study found that investors who checked their portfolio monthly became more risk averse than those who checked once a year.
If you're concerned about stock market volatility, one option is stock funds or ETFs that invest in more stable stocks: big, established companies such as consumer staple businesses, telecom firms and utilities, for example. Academic studies have found that stocks with lower volatility outperform riskier stocks over long periods. Read "Why boring stocks are better."
Checking your account once a quarter or every six months — and not more — may also keep you on the right track. If the markets take a dive only to recover a few weeks later, you won't notice the impact on your investments. Emotionally — and hopefully in the long run, financially — you'll be better off.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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