Family & Home: Short-Term Investments

Reallocating Your Portfolio
By SmartMoney.com Staff

YOU'VE SPENT YEARS saving. Now, as your goal rapidly approaches (whether it's the down-payment on a house, the purchase of a new car, or the tuition bills of your first child), it's time to rebalance your portfolio for a short-term horizon. After coming this far, you can't afford to lose money due to a bump in the market.

"What to sell? First, look around for your losers. If nothing else, you can use your losses to offset your capital gains at tax time."

The first thing you want to do is review your overall asset allocation to find out if you have the ideal mix of stocks, bonds and cash. You want to keep the allocation intact after your short-term money is removed. Let's say you've got $100,000 that's 70% invested in stocks, 20% in bonds and 10% in cash, and you need to take out $25,000 for the down payment on a house. You'll want to rejigger the remaining $75,000 to meet your long-term allocation: That is, you'll go down to $52,500 in stocks, $15,000 in bonds and $7,500 in cash.

If your allocation is correct, you could simply sell a little of everything and be done with it. But that may not make sense if you're sitting on investments with continued growth potential. Instead, you may need to do a little strategic pruning to maximize those holdings that still make sense going forward, while cutting back on those that don't.

Down and Out

What to sell? First, look around for your losers. If nothing else, you can use your losses to offset your capital gains at tax time.

Here are a few things to look for in a losing stock:

• Does the company have a recent history of missed earnings? Has the company's earnings outlook been trimmed?
• Has management changed for the worse?
• Has the stock fallen below $10 a share? (Many institutions are reluctant to buy below that price, so the stock may languish there.)

If you answered yes to two or more of these questions -- and you have capital gains to offset -- you should consider selling. Of course, consider your answers in relation to the stock's corresponding price performance. A 5% trim in a company's earnings outlook that has set off a 50% slide in its share price may leave it compellingly cheap.

Selling funds is easier. Has your fund consistently lagged its peer group in recent years? If so, you may want sell it -- or at least trim it back.

The Winners' Circle

As for winners, be careful about simply selling stocks with the highest price-to-earnings (P/E) ratios. Over the past decade that strategy would have eliminated many of the best-performing stocks -- Intel (INTC), Microsoft (MSFT) and Dell (DELL), to name a few -- before they posted their biggest gains. Instead, look at stocks' P/E ratios relative to their long-term earnings growth projections by using the price/earnings-to-growth, or PEG, ratio.

Keep in mind that a share-price gain of 50% or even 500% means nothing unless it's compared with changes in earnings and the rate at which those earnings are projected to grow. Also, measures like margins and return on equity taken by themselves mean less than recent changes in those numbers -- a stock with a lousy but improving operating margin can be a great investment.

For winning stocks that you're thinking about selling, ask all of the above questions for losing stocks that apply, plus the following:

• Has this stock already fulfilled the expectations I had when I bought it?
• If it was a value stock then, is it now priced on par with its peers?
• If it was a growth stock, has its earnings growth rate now slowed?
• Is the stock's PEG ratio no longer as attractive as when I bought it? Is it higher than those of its peers and the overall market?

"Yes" answers indicate it's time to get out.

Taxing Times

Finally, try not to sell stocks or funds you've held for one year or less. Why? Because then you'll be stuck paying short-term capital gains, which are taxed at the same rate as your regular income. In other words, you could have to pay as much as 35% on the sale (in 2005). Meanwhile, most long-term capital gains (on investments held for more than one year) are taxed at a maximum of just 15%. That's a pretty good reason to hang on for at least a year.

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