Cleaning Up a Messy Portfolio
How to fix your portfolio mistakes.
Last week I talked about the most common mistakes I see people make in their portfolios. Here’s a review:
Too Many Holdings
Redundancy
Contradictory Strategies
High Fees
Too Much Risk
If this describes your portfolio in any way, let’s talk about how to unwind your holdings and align your portfolio with your investment objectives.
You have two options:
Rip off the band-aid by selling everything and start over
Slowly unwind your problematic holdings over time
In most cases, it’s probably worth ripping off the band-aid and starting fresh. If you’re making a mistake today, there’s no reason to continue it any further. Selling investments in a tax-advantaged account — traditional IRA, Roth IRA, 401(k), 403(b), 457(b), TSP, SEP-IRA, HSA — won’t create a taxable event as long as transactions stay within the account so there’s no reason to hesitate.
Things get more complicated if your investments are in taxable accounts. If this is the case and you have substantial capital gains, you may want to be more thoughtful in your approach. You’ll need to consider the size of the capital gains you’re sitting on, whether they are long-term or short-term capital gains and the tax rate you’ll pay on them.
More importantly, you need to figure out what adjustments to make to your portfolio, and for that, you need to first define your objectives.
Define Your Objectives
Portfolio management requires understanding your goals and how certain investments align with those goals.
Do you want to index? Do you want to tilt toward value or growth strategies? What role do bonds play based on your age and risk tolerance? Decide this before looking at your holdings and evaluating whether they are in line with your objectives.
Not everyone knows what their objectives are or what strategies are appropriate, especially if they are completely new to investing. A U.S.-based long-term investor should start with a baseline of two funds with a 75/25 split: a U.S. total stock market fund (like VTI) and a total international fund (like VXUS). If you’re 50 or older, you can add a total bond market fund (like BND).
Look at your holdings and start identifying inconsistencies with your objectives. Own a large-cap growth fund? Don’t know why you own a large-cap growth fund? Then get rid of it. Same goes for small-value funds. I’m a big fan of those, but I don’t think investors who don’t know why they own them should have them. Anything beyond a market-cap-weighted index fund needs to be justified by a coherent strategy.
A lot of people hold an S&P 500 index fund and QQQ without realizing they’re doubling up on mega-cap growth tech stocks. The stock market is already highly concentrated in this sector. Do you really want more of that?
Another issue I see is sector funds. People buy broad market funds like S&P 500 or total stock market funds but then buy healthcare sector funds, financials or real estate. They probably do this thinking they’re diversifying, but it’s just redundant exposure to stocks already contained in index funds. If your strategy is to overweight healthcare funds, I’m not going to tell you what to do with your investments. But I doubt most people who do this understand why they’re doing it.
The most important factors to consider when creating a portfolio are your goals and your risk tolerance. A stock-heavy portfolio reflects a long-term goal. A portfolio with a substantial allocation to bonds signifies a lower risk tolerance.
A three-fund portfolio is perfectly suited to adapting to any goal or risk tolerance, which is why it should serve as a baseline before thinking about factor tilting or overweighting. It also helps keep fees low, which is another thing inexperienced investors overlook.
How to Clean Up Your Portfolio
If you have a tax-advantaged account, you can sell everything at once and start over. If your portfolio already contains funds you want to keep, you can leave them be and just sell the ones you want to get rid of, but I find that starting from zero makes it easier to arrive at your exact allocation.
What if you’re cleaning up a taxable brokerage account? First, you need to understand how investments are taxed. Depending on how long you’ve held your investments, they will be subject to short-term capital gains or long-term capital gains.
Short-term capital gains apply to investments held for less than a year and are taxed as ordinary income. The rates range from 10% to 37%. Offloading short-term gains can be the most brutal, but unless you got really lucky with a short-term trade, you probably aren’t sitting on huge gains anyway.
Long-term capital gains apply to investments held for more than a year and are taxed at much more favorable rates: 0%, 15% and 20%. Long-term capital gains will be the easiest to unwind because it’s possible you won’t have to pay any tax at all. This is way more common than you think and more than doable with a little tax maneuvering.
The most you’ll have to pay is 20%, which is much better than the highest ordinary income tax bracket. Some high earners also need to pay the net investment income tax (NIIT). Of course, you still have to consider state taxes, but there’s no room here to go through each state’s unique tax rates and structure.
With all that said, look at the capital gain situation in your account. Most brokerage platforms have this information accessible, down to how many are short-term and long-term. From there you can roughly estimate your tax bill and decide if that’s something you can handle. It might be optimal to slowly unwind your holdings so that you spread the tax hit out over multiple years depending on how big your gains are.
Another approach could be to prioritize which holdings you get rid of first. If you have really wild stuff like ARK funds or leveraged ETFs, those can go first. Then you can get rid of sector funds followed by growth and/or value depending on where your investment objectives land. Some investments might be ok to hold a bit longer while others you want to get out of quickly.
Everyone will make mistakes with their portfolio at some point. When you realize you’re making mistakes, update your investment strategy and align your investment allocation with your goals. Take a look at your portfolio. If something doesn’t align with your goals, consider consolidating, swapping out and cleaning things up as needed.