It is good practice to conduct a (semi-)annual portfolio review and rebalance it by bringing down the weight of outperforming stocks as well as bringing up or selling out of underperformers. Done before the end of the tax year, it allows to size the trades in a such a way that the tax bill be minimised (by offsetting the gains from selling down outperformers with the losses from selling out of selected underperformers).

Table

Given that a great portfolio is defined by few outstanding winners whose returns vastly compensate for the few(er) outstanding losers (see example in the table above), it is inevitable that the faster rising value of the outstanding winners leads to portfolio weights that end up being a multiple of the losers’ (eg. Fevertree at 7.5% vs. Shimano at 3.0%).

Rebalancing consists of bringing back in line those holding weights that have gone materially above or below the weights they used to have originally (say by +/- 1% from target which in the illustration above would involve Fevertree, Ferrari, Pandora, and Shimano). Such decisions should be based on the investor’s assessment of each stock’s fundamental merits, with tax implications a secondary consideration

(Semi-)Annual Portfolio Review

At least one such review should be conducted annually toward the end of one’s fiscal year (although not right at the end as one must allow for trades to be settled, so no later than 3-4 days before year end). The process is about reaffirming (or revising) one’s conviction on each stock (based on key market/competitive/regulatory/etc. reasons to believe that the stock stands a high chance of winning in the future). This needn’t be a lengthy process, especially if one has been keeping informed on each holding throughout the year. In the example above, let’s assume the investor:

  • reaffirmed high convictions in Fevertree and Ferrari, so will only realise part of her gains by selling some shares in both stocks so their portfolio weight drops back to 5%
  • lost conviction in Shimano (hence decided to cut her losses and sell out of the stock), but kept faith in Pandora (hence will buy more shares up to a level representing 5% of the portfolio)
  • use the proceeds of the sale to buy shares in a new holding, Ipsen

Tax Loss Harvesting considerations

Because tax authorities allow to offset taxable capital gains (ie. tax on the sale of stocks whose price has gone up since purchase) against capital losses (i.e. tax credit generated following the sale of a stock whose price has gone down since purchase), investors should seek to minimise their tax liability. In the example above, the sale of Shimano (low conviction holding) generates a tax credit that completely offsets the CGT (set at 50% in this example) created by rebalancing the weights of Fevertree and Ferrari. With no tax liability created, the investor pockets the full $8,000 proceeds from the sale, which can be used to buy more Pandora shares ($1,750) as well as Ipsen shares ($5,500).

Result

The resulting portfolio still consists of 20 holdings, but Ipsen has replaced Shimano, and all holdings weights have been rebalanced to 5% of portfolio. Portfolio value is now $109,280, with the $750 balance to the initial $110,030 realised as tax-free cash, thanks to decisions that improved the portfolio without triggering any tax liability.