Rebalancing: The How, When, and Why

If there is a universal investment ideal, it is this: Every investor wants to buy low and sell high.

What if we told you there is a disciplined process for doing just that, and staying on track toward your personal goals while you’re at it? Guess what…There is. It’s called rebalancing.

 

Rebalancing: How It Works

Imagine it’s the first day of your investment experience. As you create your new portfolio, it’s best if you do so according to a personalized plan that prescribes how much weight you want to give to each asset class. So much to stocks, so much to bonds … and so on. Assigning these weights is called asset allocation.

Then time passes. As the markets shift around, your investments stray from their original allocations. That means you’re no longer invested according to plan, even if you’ve done nothing at all; you’re now taking on higher or lower market risks and expected rewards than you originally intended. Unless your plans have changed, your portfolio needs some attention.

 

But Why rebalance?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future and there’s no reliable way to predict future returns.

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork. This is what rebalancing is for: to shift your assets back to their intended, long-term allocations – systematically buying low and selling high.

 

Portfolio Balancing: A Closer Look

We’ve now shared a simple rebalancing illustration. In reality, rebalancing is more complicated, because asset allocation is completed on several levels. First, we suggest balancing your stocks versus bonds, reflecting your need to take on market risk in exchange for expected returns. Then we typically divide these assets among stock and bond subcategories, again according to your unique financial goals. For example, you can assign percentages of your stocks to small- vs. large-company and value vs. growth firms, and further divide these among international, U.S., and/or emerging markets.

 One reason for these relatively precise allocations is to maximize your exposure to the right amount of expected market premiums for your personal goals, while minimizing the market risks involved by diversifying those risks around the globe and across sources of returns that don’t always move in tandem with one another. We, and the fund managers we typically turn to for building our portfolios are guided by these tenets of evidence-based investing.

It’s scary to do in real time. Everyone understands the logic of buying low and selling high. But when it’s time to rebalance, your emotions make it easier said than done. To illustrate, consider these real-life scenarios.

 

When markets are down:

Bad times in the market can represent good times for rebalancing. But that means you must sell some of your assets that have been doing okay and buy the unpopular ones. The Great Recession of 2007–2009 is a good example. To rebalance then, you had to sell some of your safe-harbor holdings and buy stocks, even as popular opinion was screaming that stocks were dead. Of course history has shown otherwise; those who did rebalance were best positioned to capture available returns during the subsequent recovery. But at the time, it represented a huge leap of faith in the academic evidence indicating that our capital markets would probably prevail.
 

Those who did rebalance were best positioned to capture available returns during the subsequent recovery.

 

When markets are up:

An exuberant market can be another rebalancing opportunity – and another challenge – as you must sell some of your high flyers (selling high) and rebalance into the lonesome losers (buying low). At the time, this can feel counterintuitive. But disciplined rebalancing offers a rational approach to securing some of your past gains, managing your future risk exposure, and remaining invested as planned, for capturing future expected gains over the long-run.

 

The Rebalancing Take-Home

Rebalancing using evidence-based investment strategies makes a great deal of sense once you understand the basics. It offers objective guidelines and a clear process to help you remain on course toward your personal goals in rocky markets. It ensures you are buying low and selling high along the way. What’s not to like about that?

At the same time, rebalancing your globally diversified portfolio requires informed management, to ensure it’s being integrated consistently and cost effectively. An objective advisor also can help prevent your emotions from interfering with your reason as you implement a rebalancing plan. Helping clients periodically employ efficient portfolio rebalancing is another way [firm name] seeks to add value to the investment experience

In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort

No one knows where the capital markets will go and that’s the point.

 

 

 

In our most recent Market Review, for the 4th Quarter 2017 we provide a general report and perspective on global market activity during the most recent quarter and for the full year 2017. 

4th Quarter and Full Year 2017 Market Review

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services

 

 

Tax Cuts and Jobs Act: Tax Reform Overview

 

The Tax Cuts and Jobs Act (TJCA) is sweeping tax legislation that fundamentally changes the individual and business tax landscape.

While many of the provisions in the new legislation are permanent, others (including most of the tax cuts that apply to individuals) will expire in eight years. Some of the major changes included in the legislation that affect individuals are summarized below; unless otherwise noted, the provisions are effective for tax years 2018 through 2025.

Individual Income Tax Rates

Brackets

Before After
10% 10%
15% 12%
25% 22%
28% 24%
33% 32%
35% 35%
39.6% 37%

The legislation replaces most of the seven current marginal income tax brackets (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) with corresponding lower rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The legislation also establishes new marginal income tax brackets for estates and trusts, and replaces existing “kiddie tax” provisions (under which a child’s unearned income is taxed at his or her parents’ tax rate) by effectively taxing a child’s unearned income using the estate and trust rates.

 

Single Returns  
If taxable income is: Then income tax equals:
Not over $9,525 10% of the taxable income
Over $9,525 but not over $38,700 $952.50 plus 12% of the excess over $9,525
Over $38,700 but not over $82,500 $4,453.50 plus 22% of the excess over $38,700
Over $82,500 but not over $157,500 $14,089.50 plus 24% of the excess over $82,500
Over $157,500 but not over $200,000 $32,089.50 plus 32% of the excess over $157,500
Over $200,000 but not over $500,000 $45,689.50 plus 35% of the excess over $200,000
Over $500,000 $150,689.50 plus 37% of the excess over $500,000

 

Married Individuals Filing Joint Returns  
If taxable income is: Then income tax equals:
Not over $19,050 10% of the taxable income
Over $19,050 but not over $77,400 $1,905 plus 12% of the excess over $19,050
Over $77,400 but not over $165,000 $8,907 plus 22% of the excess over $77,400
Over $165,000 but not over $315,000 $28,179 plus 24% of the excess over $165,000
Over $315,000 but not over $400,000 $64,179 plus 32% of the excess over $315,000
Over $400,000 but not over $600,000 $91,379 plus 35% of the excess over $400,000
Over $600,000 $161,379 plus 37% of the excess over $600,000

Standard deduction (Reverts to pre-existing law after 2025)

The legislation roughly doubles existing standard deduction amounts, but repeals the deduction for personal exemptions. Additional standard deduction amounts allowed for the elderly and the blind are not affected by the legislation and will remain available for those who qualify. Higher standard deduction amounts will generally mean that fewer taxpayers will itemize deductions going forward. Additional standard deduction amount remains if you are over 65.

Filing Status Before Tax Cuts and Jobs Act After Tax Cuts and Jobs Act
Single $6,500 $12,000
Head of Household $9,550 $18,000
Married Filing Jointly $13,000 $24,000

 

Itemized deductions

The overall limit on itemized deductions that applied to higher-income taxpayers (commonly known as the “Pease limitation”) is repealed, and the following changes are made to individual deductions:

  • State and local taxes — Individuals are only able to claim an itemized deduction of up to $10,000 ($5,000 if married filing a separate return) for state and local property taxes and state and local income taxes (or sales taxes in lieu of income).

 

  • Home mortgage interest deduction — Individuals can deduct mortgage interest on no more than $750,000 ($375,000 for married individuals filing separately) of qualifying mortgage debt. For mortgage debt incurred prior to December 16, 2017, the prior $1 million limit will continue to apply. No deduction is allowed for interest on home equity indebtedness – except for ‘acquisition indebtedness used to improve primary residence that secures the primary mortgage.

 

  • Medical expenses — The adjusted gross income (AGI) threshold for deducting unreimbursed medical expenses is retroactively reduced from 10% to 7.5% for tax years 2017 and 2018, after which it returns to 10%. The 7.5% AGI threshold applies for purposes of calculating the alternative minimum tax (AMT) for the two years as well.

 

  • Charitable contributions — The top adjusted gross income (AGI) limitation percentage that applies to deducting certain cash gifts is increased from 50% to 60%.

 

  • Casualty and theft losses — The deduction for personal casualty and theft losses is eliminated, except for casualty losses suffered in a federal disaster area.

 

  • Miscellaneous itemized deductions — Miscellaneous itemized deductions that would be subject to the 2% AGI threshold, including tax-preparation expenses and unreimbursed employee business expenses, are no longer deductible.

Personal exemptions

The new legislation eliminates the personal exemption.

Amount Before TCJA  After TCJA 
Personal Exemption Amount $4,050 per person N/A ($0)

Child tax credit

The child tax credit is doubled from $1,000 to $2,000 for each qualifying child under the age of 17. The maximum amount of the credit that may be refunded is $1,400 per qualifying child, and the earned income threshold for refundability falls from $3,000 to $2,500 (allowing those with lower earned incomes to receive more of the refundable credit). The income level at which the credit begins to phase out is significantly increased to $400,000 for married couples filing jointly and $200,000 for all other filers. The credit will not be allowed unless a Social Security number is provided for each qualifying child.

A new $500 nonrefundable credit is available for qualifying dependents who are not qualifying children under age 17.

Amount of Credit Before TCJA After TCJA
Maximum Credit per Qualifying Child $1,000 $2,000
Nonrefundable credit for dependants who are not qualifying children N/A $500

529 Plan Education Accounts

529 plan distributions can now be used tax-free for private elementary and secondary school expenses (for up to $10,000 in distributions per student each year), and includes both public, private, or religious schools. Homeschooling expenses are not eligible.

Alternative minimum tax (AMT)

The AMT is essentially a separate, parallel federal income tax system with its own rates and rules — for example, the AMT effectively disallows a number of itemized deductions, as well as the standard deduction. The legislation significantly narrows the application of the AMT by increasing AMT exemption amounts and dramatically increasing the income threshold at which the exemptions begin to phase out

 

Other noteworthy changes for individuals

 

  • The Affordable Care Act individual responsibility payment (individual mandate) (the penalty for failing to have adequate health insurance coverage) is permanently repealed starting in 2019.

 

  • In a permanent change that starts in 2018, Roth conversions cannot be reversed by recharacterizing the conversion as a traditional IRA contribution by the return due date.

 

  • For divorce or separation agreements executed after December 31, 2018 (or modified after that date to specifically apply this provision), alimony and separate maintenance payments are not deductible by the paying spouse, and are not included in the income of the recipient. This is also a permanent change.

 

  • Retirement Plans – Contribution levels to retirement plans remain the same

 

  • Capital Gains – No change to the capital gains tax rates or the ability to sell specific shares.

 

  • Estate Tax Exclusion – The act doubles the gift and estate basic exclusion amount to $11,200,000 (per spouse) This reverts to previous amount $5,100,000 in 2025.

 

 

Noteworthy changes for Businesses or Business Owners

 

  • Corporate tax rates – Instead of the previous graduated corporate tax structure with four rate brackets (15%, 25%, 34%, and 35%), the new legislation permanently establishes a single flat corporate rate of 21%. This provision will not expire in 2025.

 

  • Pass-through business income deduction – Individuals who receive business income from pass-through entities (e.g., sole proprietors, partners) generally report that business income on their individual income tax returns, paying tax at individual rates. For tax years 2018 through 2025, a new deduction is available equal to 20% of qualified business income from partnerships, S corporations, and sole proprietorships. For those with taxable incomes exceeding certain thresholds, the deduction may be limited or phased out altogether, depending on two broad factors: The deduction is generally limited to the greater of 50% of the W-2 wages reported by the business, or 25% of the W-2 wages plus 2.5% of the value of qualifying depreciable property held and used by the business to produce income.

 

  • The pass-through income deduction is phased out for certain businesses that involve the performance of services in fields including health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial services. For those with taxable incomes not exceeding $157,500 ($315,000 if married filing jointly), neither of the two factors above will apply (i.e., the full deduction amount can be claimed). Those with taxable incomes between $157,500 and $207,500 (between $315,000 and $415,000 if married filing jointly) may be able to claim a partial deduction.

 

IMPORTANT DISCLOSURES

The information presented here does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.