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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Saturday, October 31, 2009

It’s Harvest Time Again!

Halloween is here; the cold of winter is approaching and farmers are all clearing their fields, harvesting the last of the year’s crops to prepare for next year’s planting. Between now and year-end, we need to consider some harvesting of our own to take advantage of the year’s tumultuous markets and minimize any losses remaining in our portfolio. Losses in taxable accounts can be “harvested”, resulting in significant income tax savings that will mitigate the huge losses we have all seen the last two years in our portfolios.

All too often investors have a tendency to hold on to their winners and losers too long. They don’t want to part with losers because they’re sure that as soon as they do, the losing investment will rebound. They can’t stand the thought of selling and then missing out on a miraculous recovery. They overlook the fact that if they sold the loser, they could mitigate their loss by writing off the loss on their tax return and then replace the poor-performing asset with one that has a better probability of providing a good solid return going forward.

As for holding on to winners too long, investors have similar fears; what if they sell a winner and then lose out on future gains? Or, they hold on to winners to avoid having to pay taxes on their gains. Letting taxes get in the way of doing what’s right from an investment standpoint, is a common mistake. You need to establish a target selling price when you purchase a stock. When it reaches that price, you should sell the stock unless you can make a sound argument as to why that stock remains undervalued. Keep in mind too, that a significant increase in the capital gains tax is highly likely going forward.

So, with the 2009 tax year coming to an end, it’s time to “harvest” your winners and plow up your losers. Even though the market has risen sharply in recent months, you may still have significant losses in your taxable accounts. And, if you haven’t rebalanced your portfolio recently, trimming over-allocated asset classes could reduce your portfolio risk significantly. With the economy still facing high unemployment and more real estate foreclosures, many worry about another market pullback. Selling some winners may be a wise move.

If you focus on the tax savings from selling losers and the current low capital gains rate, it will help motivate you to take action. Often the losses will offset the gains and eliminate the potential capital gains liability.

Review your portfolio and look for assets with significant losses. It may be that the asset is worth keeping but has a significant loss that can be used to offset the gains of a winner that needs to be sold. Due to what’s called the “wash-sale rule”, you can’t just sell the asset and then re-purchase it. IRS rules require you to wait 30 days before re-buying, else you lose the right to write off the loss. There may be a way around this rule, however.

For example, let’s suppose you have a substantial holding in the Fidelity Spartan 500 Index fund that is still down significantly from your purchase price. You’d like to sell the fund but want to maintain your position in large domestic stocks, in case the market continues its upward swing. You can sell the Fidelity fund and immediately buy a somewhat similar fund (such as the Vanguard Total Stock Market Index Fund). You may want to check with your tax advisor to be sure the new fund is not essentially the same as the one you sold. IRS rules are unclear as to what they consider to be essentially the same fund. This is a gray area that you need to be pay attention to. In the case where the holding is a stock, you may be able to find a similar stock in the same industry in order to maintain your position in the market.

You also need to analyze your winners to determine those that have reached their target selling price and should be sold. You should also look for stocks that have done so well that they now represent more than 5% to 10% of your total portfolio’s value. Often these holdings are in stock of the company you work for or for which you have strong emotional ties (e.g. inherited from your parent). Nevertheless, a stock holding of more than 5% to 10% of your portfolio adds significant risk that should be avoided. Having too much stock in the company you work for is a big mistake. When times get bad, companies layoff people or give early retirements. At the same time, your company’s stock price will likely be low, just when you may need it the most. ”Harvest” time is a good time to trim those holdings too, since losses from losers can help mitigate the taxes from possible gains.

So, as we point out every year to our clients at this time, let the falling leaves be a reminder to take a look at your portfolio and do some “harvesting”!


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