As the market gears up a bit, people are re-evaluating their portfolios and wondering how to invest in today’s economic environment. A change in personal circumstances can also warrant a change in investment approach.
I’ve always been a fan of mutual funds. They take less time because, once you choose the funds, professional managers watch the market for you and make buying and selling decisions. And funds make it easy to invest in a wider variety of stocks, which is a great way to help manage risk. So there are a lot of pluses — as long as you do your research when choosing funds and don’t rely only on past performance.
The benefits of mutual funds aside, the wisdom of switching from individual stocks to funds depends largely on what’s best for your overall portfolio from an investment standpoint and from a tax standpoint. Here are some things to consider.
The percentages. Paring down speculative stocks and focusing on blue chips, which represent well-established and financially sound companies, makes sense. If you’re trying to decide whether to move more toward mutual funds, first look at the percentages. If individual stocks are just a small part of your total stock portfolio and you have at least some time to follow them that seems reasonable. However, if individual stocks represent the lion’s share of your overall investments, switching more of your assets to mutual funds makes a lot of sense both in terms of “saving time” and “spreading risk.”
Be tax smart. If you do decide to sell, do it in a way that puts the most money in your pocket. This means using capital gains and losses to your advantage. Here are some things to keep in mind:
• A capital gain or loss is the difference between the amount you realize in the sale and your cost basis. What you realize is generally the sales price minus commissions. Cost basis is what you paid for the stock, plus any commissions and fees. For example, if you buy 100 shares of XYZ for $1,000 plus a $10 commission, then sell your shares two years later for $1,500 and pay a $10 commission, your capital gain would be $1,490 minus $1010, or $480. If your basis is less than what you realize from the sale, you have a capital gain. If your basis is greater than what you realize, you have a capital loss.
• When selling investments that have appreciated in value, remember that capital gains tax rates — currently a maximum of 15 percent — only apply to long-term investments (held for more than a year). Short-term investments (held for a year or less) are taxed as ordinary income.
• Don’t rule out selling investments that have gone down in value, especially if you have a better alternative, as you can use capital losses to offset capital gains. If your total losses are greater than your total gains, you can deduct the excess against your ordinary income up to $3,000 per year. If your excess capital losses are greater than $3,000, you can carry the remaining amount forward to subsequent years without expiration.
Note: If you have gains and losses, both long term and short term, you’ll need to match them against each other in a certain order to calculate your tax bill. Tax preparation software does this automatically for you, or your accountant can help you. If the top capital gains tax rate increases in the next few years, selling some or all of your appreciated stocks before then could be a smart move, but only if it makes sense to do so anyway — it typically isn’t wise to sell “just” for tax purposes. You might also benefit by selling stocks that have taken a beating in order to proactively harvest capital losses (up to the amount of any offsetting capital gains, plus $3,000 of ordinary income) to lower this year’s income tax bill.