1 Smart Investment Move to Make in December

By Markets Fool.com

Continue Reading Below

Successful investing is a balancing act. Source: Flickr user kevint3141.

With the end of the year approaching, it's a good time to take a close look at your portfolio, see how you did this year, and adjust your holdings accordingly -- this is known as "rebalancing." Rebalancing your portfolio is an important investment move that you should do from time to time.

Here's why it's so important and how you can get started.

Did any of your stocks have a great (or awful) 2014?
Over time, different stocks perform differently. Even if your portfolio is completely diversified, over time your best performers will begin to make up a disproportionately large portion of your portfolio.

Let's take a look at a hypothetical example of an investor who bought $10,000 worth of each of the following five stocks in 2010:Apple , Johnson & Johnson , ExxonMobil , Wells Fargo , and Target . So, originally each stock made up 20% of the total portfolio.

Continue Reading Below

Since they were purchased, these stocks have produced widely varying returns:

AAPL Chart

So, in December 2014, our portfolio would now look something like this:

Stock Ticker Original Value Total Return Current Value % of Portfolio (2014)
Apple AAPL $10,000 297.2% $39,720 35%
Johnson & Johnson JNJ $10,000 97.7% $19,770 17%
ExxonMobil XOM $10,000 54.5% $15,450 14%
Wells Fargo WFC $10,000 124.1% $22,410 20%
Target TGT $10,000 70.3% $17,030 15%
Total $50,000 129% $114,380

As you can see, the portfolio has become disproportionately weighted toward Apple, which now makes up 35% of the total portfolio. The problem here is that if Apple has a bad year in 2015, our portfolio will be devastated. On the other hand, if ExxonMobil or Target has a good year, we won't see as much of a gain as we should.

Reduce your exposure to the big winners
Keep in mind that there's no need to be nitpicky. If you own five stocks, and some account for slightly more or less than their original portion of your portfolio, there's no need to sell a few shares to balance it out. On the other hand, if any of your stocks now make up a truly disproportionate amount of your portfolio like in our example above, now may be a good time to take some of your profits off the table.

In our example, since most of our holdings now represent between 15% and 20% of the portfolio, I may sell about $17,000 worth of Apple stock, which would bring it back down to 20% of my holdings. And I could either put that money into my underweight stocks like Target or use it to initiate a new position in another stock that I like. Either option will produce a diversified portfolio in which all investments are weighted similarly.

A word about taxes
It's worth mentioning that when you sell some of your winning investments, you'll likely be required to pay taxes on the gains. Fortunately, there are some tax-saving moves you can make before the end of the year.

First, do you have any losing investments that don't seem to be going anywhere? The IRS allows you to use investment losses to offset your gains, so while you're doing some rebalancing, it may be a good idea to cut your losses on some stocks that just aren't doing what you had hoped.

And if you've held your winning stocks for a year or less, you may want to hold off on rebalancing for a little while. Short-term capital gains are generally taxed at a significantly higher rate than long-term gains, so make sure you take this into account before you sell.

Finally, you always have the option of waiting until after Dec. 31 to sell anything, which makes any gains part of your 2015 taxable income.

Of course, if your stocks are held in a tax-advantaged account like an IRA, you don't need to worry about any of these tax issues.

It's all about balancing your risk
In our example, if Apple were to have a great year in 2015, we would stand to make a lot of money if we simply left everything as is. But we could also get crushed just as easily if Apple does poorly.

The point here is that by rebalancing your portfolio on a somewhat regular basis, you'll keep your portfolio's performance from relying too much on a single company. You don't want to put yourself in a position where you say things like "I really need Apple to do well again this year."

With some responsible risk management, your portfolio will have the potential to produce solid gains while still allowing you to sleep soundly at night.

The article 1 Smart Investment Move to Make in December originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Apple, Johnson & Johnson, and Wells Fargo. The Motley Fool owns shares of Apple, Johnson & Johnson, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.