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.