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.

In the preceding post we noted the risk of an unrealized capital loss becoming long-term due to a wash sale. Tax loss harvesting also creates a situation constrained by the wash sale rule.

Tax loss harvesting

As in the preceding post, suppose you bought 100 shares of BP (BP plc ADR) at $50 per share on June 15, 2009. Less than a month ago on May 26, 2010, BP stock was at $43 per share. You had an unrealized short-term capital loss of about $700.

Rather than buying more BP stock, you sold 100 shares for $4,300. This action is also known as harvesting a tax loss. This loss would offset any short-term capital gains in your taxable portfolios.

Two weeks later on June 9, BP closed at $29.20. To rebalance your asset allocation, you were anxious to restore your holding in BP. On June 10 you bought 100 shares for $3,100. This purchase triggered a wash sale and negated the whole purpose of harvesting the tax loss.

Wash sale effect on cost basis

The short-term loss that you recognized on May 26 would be disallowed as a wash sale, because you bought substantially identical stock within 30 days after the sale.

To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the tax lot for the June 10 purchase had its cost basis raised by $700 to $3,800. You also change the beginning of the holding period of the tax lot to the purchase date of the stock sold.

The tax lot now has an unrealized loss of $700, and its holding period began on June 15, 2009. On June 16, this loss became long-term.

Tax loss harvesting starts a 30-day wash sale window

Recognizing a capital loss in a taxable portfolio sets up the potential for a wash sale during the next 30 days. To avoid a wash sale that would disallow the prior capital loss, you have two choices.

You can wait 31 days after the loss before buying replacement stock. While simple, this choice has a major drawback. During the period when the portfolio lacks the holding that had been sold, your asset allocation may differ from your chosen allocation.

Yesterday, the BP ADR closed at $29.20. You have fallen into deep water, with no clear vision of the horizon.

Your 200 share position in BP consists of two tax lots. The first, year-old tax lot has an unrealized loss of about $2,100 (-$21 times 100 shares). For the second, more recent tax lot you have an unrealized loss of about $1,400.

Wash sale effect on cost basis

If you sell the first tax lot for a loss, you cannot deduct that loss from your net capital gains. The loss would be disallowed as a wash sale, because you bought substantially identical stock within 30 days prior to the sale.

This is the point where most discussions of the wash sale rule end. But the real damage has only just begun.

To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the second tax lot has its cost basis raised by $2,100 to $6,400. You also change the beginning of the holding period for the second tax lot to the purchase date of the stock sold.

The second tax lot now has an unrealized loss of $3,500, and its holding period began on June 15, 2009. Next week, on June 16, this loss will become long-term.

Avoid a wash sale that creates a long-term capital loss

Before your recent purchase two weeks ago, the first tax lot had an unrealized loss of $700. More significantly, the holding period for that lot was approaching one year. An earlier post pointed out the importance of recognizing short-term losses before they become long-term.

Adding to a stock position which has an unrealized capital loss starts a 30-day wash sale window. During that window, a sale of the stock for a loss will be disallowed. Particularly worrisome is when the window stretches the holding period of a tax lot beyond one year.

Buy and hold

You have decided to buy and hold a portfolio of 10 stocks in a $100,000 portfolio. After four months, the total value of the portfolio has risen to $103,000. One stock, Bank of America (BAC), has dropped 30% to just $7,000, but most of the other holdings have gains.

Given your belief that BAC will bounce back from its loss, you hold onto it. Six months later, the portfolio value is $110,000. The BAC has recovered all of its loss and has a value of $11,000.

Replace a losing stock with a similar stock

Rather than holding onto the BAC after it had dropped, assume that you sold it to realize a $3,000 short-term loss. With the proceeds from the sale, you purchased $7,000 of Wells Fargo (WFC). Replacing the BAC with a similar financial stock helped to maintain the portfolio diversification.

As before, the portfolio value rose to $110,000 six months later. At that point, the WFC position had also risen to a value of $11,000.

Tax loss harvesting

Capital gains tax works in reverse for a capital loss: for the benefit of the taxpayer. You can exclude from your taxable income up to $3,000 in capital losses. If you are subject to the top 35% marginal tax rate, this exclusion lowers your tax by $1,050.

By proactively selling a stock and harvesting a loss, you gained a tax savings. The simple buy and hold approach left $1,050 on the table. If you chose to invest the savings, tax harvesting would have raised your portfolio value to $112,050.

Buy and hold could give away a tax break

Each year, taxpayers may subtract up to $3,000 in capital losses from their ordinary income. For those in the 35% tax bracket, this amounts to a tax reduction of $1,050.

Under a buy and hold strategy, an investor may not have sold any stock during 2009. By doing so, he would have avoided paying any capital gains tax.

If this investor’s portfolio had nothing but unrealized gains, he could do no better. Most investors are not that fortunate.

Sell to realize a capital loss and get a tax break

No investor is perfect with their stock picking. Anytime a new stock is purchased, a risk exists that its price may fall.

By selling a stock for a loss, an investor can lower his overall capital gains. If he realizes losses equaling $3,000, he enjoys the maximum tax break.

Offset further losses with capital gains

If the total capital loss exceeds $3,000, the excess is carried forward to the next year. Delaying by a year the benefit of the tax break dilutes its value, due to the time value of money.

One way to avoid a capital loss carry forward is to sell a different stock for a gain. This also provides a convenient chance to improve the degree of portfolio diversification. Overweighted stocks tend to be those with unrealized gains.

Let long-term capital gains wait a little longer

With its tax rate of only 15%, some investors might choose to realize a long-term capital gain. As discussed in an earlier post, unless the investor is retired and no longer adding money to the portfolio, taking such a gain is unnecessary and costly.

Get the maximum tax reduction on Schedule D

An individual’s Schedule D could have a net short-term loss of $3,000, with zero long-term capital gains. In this case, he will benefit from the maximum tax break for capital losses.

If his portfolio has unrealized losses and he reports a smaller loss, or even a gain, he may be just another irrational investor.

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.

Almost one year ago, on September 24, 2008, an investor bought 200 shares of stock at a price of $60. Today, the latest quote for the stock is $45. This drop of $15 gives her an unrealized short-term loss of $3,000.

Tax loss selling at year-end

Many investors review their portfolios before the end of each year. Because capital losses offset gains, some sell stock at that time to realize losses for the current tax year. In fact, some academic studies credit this practice of selling for part of the so-called January effect.

She may hope that between today and the end of the year, the stock price may rise above $45. Then again, it may not. What is certain is that 10 days from now (September 25, 2009) the basis of the stock will become long-term. If she sells the stock for a loss in December, she will realize a long-term capital loss for the 2009 tax year.

Tax loss harvesting year-round

An earlier post showed the tax savings advantage of a short-term loss relative to a long-term loss. By waiting until December to sell, she will have missed the chance in September to realize a short-term capital loss.

Investors purchase stock at all times of the year. This means that the holding period for stock purchased within the last twelve months will also change from short-term to long-term throughout the year.

By making a habit of taking capital losses in December, an investor risks having a number of long-term capital losses. Taking those losses earlier in the year will help avoid that mistake.

Holding onto a short-term capital gain until it becomes long-term can save a lot of tax. This does not hold true with a short-term loss.

A mix of realized gains year to date

An investor already has $10,000 of realized capital gains. Half of these gains, $5,000, are short-term and half are long-term. Subject to the top marginal tax rate, the short-term gains would incur a tax of $1,750 ($5,000 times 35%). The tax on the long term-gains, using the 15% rate, would be $750 ($5,000 times 15%).

Overall, she expects to pay a tax of $2,500, on gains totaling $10,000.

Realizing a long-term loss

Thirteen months ago she bought 300 shares of stock at $40. The stock price has since dropped to $30. Her $12,000 investment has lost 25% of its value and is now worth $9,000.

If she sells the stock, she will realize a $3,000 long-term loss ($12,000 – $9,000). Added to her other long-term gains, the loss will lower her long-term gains to $2,000 for the year. The tax on the long-term gains would drop to $300 ($2,000 times 15%).

As the capital gains tax now totals $2,050, taking the loss has saved her $450.

Better yet: take an earlier short-term loss

Six weeks earlier, that same stock had a price of $30. She was already holding a short-term loss. Had she sold the stock at that time, she would have realized a $3,000 short-term loss. This loss would have offset the other short-term gains, rather than the long-term gains. With the total short-term gain now just $2,000, its tax would have fallen from $1,750 to just $700.

Her total capital gains tax would have been $1,450 ($700 plus $750). By taking this loss earlier, she would have saved $1,050 in tax.

Why waste the tax savings of a loss by offsetting a long-term gain?

Taking a long-term loss, rather than a short-term loss, missed a chance to save $600 in tax. This happened because a short-term loss has its highest value when it offsets other short-term gains or ordinary income. After it becomes a long-term loss, it will first offset any long-term gains. Since these gains already benefit from a lower tax rate, the offset is worth less.

In 2003, a tax cut law lowered the tax rate on qualified dividends to 15%. Before then, such dividends were taxed as ordinary income at rates as high as 35%. Given this new rate, some investors may have added more high dividend stocks to their taxable portfolios.

Qualified dividends in a taxable portfolio

Suppose that an investor has a taxable portfolio worth $100,000. Each year, this portfolio receives $5,000 in dividends, equal to a yield of 5%. With the 15% tax rate, the dividends incur an annual tax of $750. This investor also has a tax-deferred IRA portfolio worth $100,000. No stock in that portfolio pays a dividend.

If the 15% tax rate on dividends were to remain unchanged, the tax would total $7,500 over the next 10 years.

Dividends in a tax-deferred IRA

Suppose instead that the investor were to place the dividend paying stock in the IRA. The taxable portfolio, with no dividends, would have no tax. Within the IRA, $5,000 in dividends would accrue each year without tax. In effect, the investor would receive an interest-free loan on the deferred $750 tax. By reinvesting what would have been paid in tax, the IRA might also gain additional return.

After 10 years, the IRA would have received $50,000 in dividends. The bad news: a withdrawal at that time would be taxed as ordinary income, rather than at the 15% dividend rate. For those expecting a 25% marginal tax rate during retirement, the tax would come to $12,500.

At first glance, receiving dividends from the taxable account appears to save $5,000.

Choosing where to place high dividend stock is not so simple

For a better comparison, the deferred tax on the IRA withdrawal can be discounted to the present time. Using a 5% annual interest rate, the present value of a $12,500 tax, ten years from now, is $7,673. For the taxable portfolio, the present value of a $750 tax, each year for 10 years, is $5,791.

After considering the value of the tax deferral, placing the dividend stock in the taxable portfolio still saves about $2,000. Note that the investor’s time horizon and tax rate during retirement would also affect the comparison.

A higher qualified dividend tax rate in 2011 spoils the party

For 2011 and beyond, ordinary dividends will again incur tax just like ordinary income. Investors receiving taxable dividends are in for a shock. First, the top marginal rate rises to 39.6%. Instead of $750, the tax on $5,000 of taxable dividends will rise to as high as $1,980 (at the 39.6% tax rate).

The choice becomes clear. Beginning in 2011, placement of dividend paying stock within an IRA account will offer a real benefit in lower taxes.

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.