No consensus exists as to the best method for building an equity portfolio. Some invest passively with index mutual funds. Others prefer a more active approach by picking individual stocks. Everyone wishes for above average returns and a secure retirement in comfort.

Regardless of individual preferences, prudent management of an equity portfolio will consider, at a minimum, these three practices:

• Asset allocation and diversification to balance risk and expected return
• Performance monitoring and adjusting holdings
• Reducing costs to a practical minimum

Doing this well can be hard work. Those who are unwilling to devote the time and effort may choose to pay a financial professional to handle their investments.

Make cost reduction easy

If you have decided to make your own investment decisions, you may have already found it surprisingly difficult to manage your equity portfolios on the web. You can track the value of your stocks minute-by-minute, but not much else. A diligent investor might have to resort to tracking their portfolios with spreadsheets.

Following the above practices should be easier. One reason we founded Realized was to give individual investors a genuine cost reduction tool.

The sell side can generate real expenses

One easy way to realize higher returns is by lowering your investment costs. And the biggest costs are not commissions or management fees, but rather the taxes on capital gains.

Most financial web sites are devoted to what might be called the buy side of investing. Financial analysts recommend countless stocks. Buying is easy and nearly cost free, with online brokerages and low commissions. You have a spectrum of choices: stocks, ETFs and mutual funds.

Almost no guidance exists about when and what to sell from your portfolios. You might be overweighted in the energy sector, but which stock should you sell? You can only sell a security that you already hold. The mass media simply has no interest in an audience of one that has a specific portfolio issue to address.

Closing a stock position also generates taxable capital gains. Selling the wrong security at the wrong time can have a catastrophic effect on your realized, after-tax investment return.

Each time a trade occurs, it also changes your asset allocation. This has the potential to change the risk versus return profile of your portfolio. Along with the control over making your own trades comes the potential for destruction.

Managing a portfolio successfully requires some discipline with regard to selling securities.

Forget about timing the market: focus on timing your portfolio

By netting out gains and losses, many investors can sharply lower their tax burden. Turning unrealized losses into actual losses allows for other sales to become literally tax-free. This helps when you want to rebalance and improve your diversification.

Some investment software apps focus on calculating your capital gains tax near the end of the year. You discover where you stand after the fact. By then, it may be too late to offset gains with losses. You are stuck with a capital gains tax that might have been avoided. This approach fails to reduce costs to a minimum.

Realized aims to change things

Should you buy this stock, or sell that one, and how would it affect my portfolio? For those investors who need a tool to assist with such decisions today, Realized can help.

An online broker might charge a $10 commission to execute a stock trade. Your cost to buy 100 shares of a $50 stock would be $5,000 plus $10.

Trade commissions reduce before-tax gain

The commission would amount to only 0.2% of the principal invested. A few months later, you sell the stock for $60. As before, you would incur a $10 commission.

After subtracting the commission costs, you net $980 before taxes. The commission has reduced your net gain by a full 2 percent.

Short-term capital gains tax far exceeds commission cost

A short-term gain brings on a tax that lowers its return by 35 percent if you are subject to the top marginal tax rate. The capital gains tax on a $980 short-term gain would total $343.

This tax cost is 17 times greater than the round-trip commissions cost.

Long-term tax rate still takes a big bite

Had you held the stock more than one year before selling, the capital gain would be long-term. Such a long-term gain is taxed at only 15 percent.

For a $980 long-term gain, the capital gains tax would total $147. Waiting to realize a long-term capital gain results in a tax cost more than 7 times that of the trade commissions.

Delay capital gains tax by delaying a stock sale

A trivial way to delay the tax cost is to delay selling the stock. While the gain remains unrealized, it incurs no costs. Unless your asset allocation plan dictates that you dispose of the position, holding an unrealized gain is the best method for lowering your investment costs in the current year.

A dollar today is worth more than a dollar next year. Postponing the tax leaves you with more cash to invest now and discounts the tax cost in a future year.

Avoid the tax by offsetting the capital gain with a capital loss

Actually, capital gains tax is not calculated individually for each stock sale. If you must sell a stock with a short-term capital gain, you might look for another holding that has an unrealized short-term capital loss.

Selling another stock with a $1,000 short-term loss will more than offset the $980 short-term gain. This would leave you with zero net capital gains tax.

Rather than waiting until you have a gain that you want to realize, you may want to employ tax loss harvesting to recognize those losses as they arise. No investor sets out to lose money after buying a stock. Those who hold onto those losses when they could use them to offset gains miss a certain way to lower their tax.

Many investors take care to wait for a gain to become long-term before selling. By doing so, they benefit from the relatively low 15% capital gains tax. Here we take another look at when to sell stock.

Delay recognition of all capital gains, even long-term gains

Once the market value of a stock position rises above its cost basis, an investor has an unrealized gain. When she sells the stock, she will realize the gain and incur a capital gains tax.

In November 2009, she had an unrealized $10,000 long-term gain. Rather than recognizing that gain in 2008, she waited until February 2010 to sell the stock position.

She has delayed a $1,500 tax, $10,000 times 15%, by one full year: April 2010 to April 2011. By postponing the tax, she can invest the $1,500 for a year and earn $75, assuming a 5% return.

Unrealized gains are even more valuable

An unrealized gain is subject to a potential, future tax. Just when that tax becomes payable is at the discretion of the investor.

The ultimate purpose of investing is to preserve wealth over time. An investor need not sell an unrealized gain. By holding the gain, the gain will compound its return and grow like a tax-deferred account, such as an IRA.

In a sense, the investor can enjoy the benefit of the compounding effect of unpaid deferred tax. If and when she needs to withdraw the money from the portfolio, she may choose to realize the gain. For many investors, that day will come during retirement.

Diversification can dampen losses

An investor has decided to diversify by holding 10 stocks in a $100,000 portfolio. To balance the portfolio, he bought equal amounts, or $10,000, of each stock.

After three months, the total value of the portfolio has not changed. Two stocks have dropped 25% to just $7,500. On the plus side, one stock is up 50% to $15,000.

Having that gain to offset the losses shows the power of diversification. Without the $5,000 gain, the overall portfolio value could have dropped to $95,000.

Market action degrades diversification

The relative weight of the $15,000 holding has risen to 15% ($15,000 divided by $100,000). Now, the portfolio is far more sensitive to a price change in that stock.

Both of the $7,500 holdings are underweighted. Due to their small size, they now have less influence on the future performance of the portfolio.

Rebalancing could trade a potential risk for a certain cost

Equalizing the weights would restore the measure of diversification. To begin, he sells one-third, or $5,000, of the $15,000 holding and realizes a short-term gain of $1,670 (one-third of the $5,000 gain). The gain also incurs a tax of $580 ($1,670 times 35%). From the proceeds of the sale, he now has $4,420 in cash.

He then adds to the two $7,500 holdings by buying $2,210 of stock in each. While he has succeeded in balancing the portfolio, its value has dropped to $99,420, due to the tax.

Bringing a single over-weighted stock back to its target weight has cost the portfolio $580. Repeating this action each quarter might present too high a price to keep the stock weighting balanced.

Offset the balancing cost by taking a loss

Instead of adding to both of the $7,500 holdings, he could have sold one of them. Recognizing a $2,500 short-term loss would more than offset the gain.

Better yet, the net loss of $830 ($1,670 minus $2,500) would provide a tax reduction of $290. The tax penalty for rebalancing has just vanished.

Not counting the tax savings, he now has $12,500 in cash from the proceeds of the two sales. With that, he could buy $10,000 in a different stock. To adjust the weight of the remaining $7,500 holding, he could also add $2,500 in stock.

But after considering the lower tax, he would also have $290 to spare.

For taxable portfolios, after-tax return can be much lower than before-tax return. One reason: short-term capital gains incur the same tax rate as ordinary income. For investors subject to the top 35% marginal tax rate, a short-term gain brings on a tax that lowers its return by 35%.

To put that into numbers, the tax cost on a $10,000 short-term gain is $3,500. That lowers its after-tax gain to only $6,500.

Unequal tax on investment gains

The tax code provides chances to reduce taxes, since not all investment gains are taxed equally. Long-term capital gains get a more favorable 15% tax rate. At $1,500, the tax cost of a $10,000 long-term gain is $2,000 less than that of a similar short-term gain.

One should note that other costs, such as trading commissions or management fees, do not even begin to approach this ‘favorable’ 15% rate.

Recognizing losses to offset gains

For a portfolio having the gains described above, the capital gains tax would total $5,000 ($3,500 plus $1,500).

Suppose that this portfolio also had stock positions with unrealized losses of $10,000 short-term and $10,000 long-term. If the investor were also to sell those positions, the realized losses would offset all of the gains. Having no net capital gain, instead of a $5,000 tax, the tax would be zero.

In this case, selling stock at a loss has preserved some of the investor’s wealth.

Figuring capital gains at the end of the year may not result in the lowest tax

Some people wait until tax season to tally their capital gains. Tax preparation software does a great job with this. So do tax preparers. Both methods should result in the same capital gains tax as reported on the Schedule D. Why?

The net capital gains are determined solely by the actual portfolio trades. Unless the losses were already taken, no realized losses would exist to offset the gains and lower the tax. Neither the expertise of an accountant, nor the ‘intelligence’ of any software, can change the realized net gains.

Consider the tax impact before making a trade

All closing trades change an investor’s net capital gains. Throughout the year many trading opportunities arise as a result of unforeseeable market action. Not all investors know the amount of their total gains when they place an order to sell stock. Those who do know have a chance to make a trade that does not expose the portfolio to avoidable tax.