A newbie undergoing his inaugural financial literacy conversion experience is disheartened a few years out of residency. His taxable account reads like a sloppy record of investing mistakes, littered with individual stocks and actively managed, high expense ratio funds.
Like many of us, he made his share of mistakes trying to beat the market before realizing that high active management fees, a lack of diversification from owning individual shares and high churn costs from rapid stock turnover were undermining his investment strategy.
He now wants to match return returns rather than beating them, and is prepared to stick with low cost, passive index fund investing.
What should he do with his "orphans," those random funds that do not align with his Investor Policy Statement?
Following are a few guiding principles to consider.
First, do no harm
If selling the orphan funds would trigger a large capital gain, consider holding onto them. It's often a bad idea to sell 1) when they've increased in value above the basis (the amount you paid at time of purchase) and 2) you have a high tax bracket due to being in your peak earning years. In this case, leave the orphans alone.
Our newbie is fresh out of residency, so he has a long investing career ahead of him. The scale of his future contributions is likely to overshadow his current investments, such that he will dilute out the impact of holding his orphans by investing everything else in index funds so they represent a smaller proportion of his portfolio over time.
Give It Away
You know who loves orphans? Charities! If you happen to hold orphan funds where selling them would cause you to incur significant capital gains (and be taxed on those gains), and you either don't need the money or have charitable giving as part of your annual budget, contributing orphans to a qualifying nonprofit organization is a win-win scenario.
Your brokerage liquidates the orphan stock(s) and sends the organization the proceeds, and the organization pays no taxes.
You simplify your portfolio, take a tax deduction and ideally help to fix broken world.
The federal government feel positive for promoting philanthropy as a civic duty among the taxpayers.
Be careful to look for the exact phrase 501(c)(3) in the organization's literature to ensure it qualifies as a nonprofit in the eyes of Uncle Sam.
If you have a donor advised fund, you can donate your orphans to your DAF and benefit from a tax deduction as well.
You may wish to consider grouping your contributions (either gifting several years of contributions in advance to your DAF) so that your larger one-time contribution makes it likelier you will exceed the standard deduction using itemized contributions under recent tax law.
Don't Let The Tax Tail Wag The Dog
Finally, you can always suck it up, take the tax hit, and sell in order to buy funds consistent with your Investor Policy Statement.
For most newbies fresh out of residency, such scenarios should not cause disproportionate angst, because if you incur capital gains it means you've made money instead of losing it. Remember that making money is your objective and should be cause for greater celebration than anxiety.
Paying capital gains on the sale of funds or individual stocks you never would have purchased knowing what you know now? That's a form of continuing financial education I like to call "The Moron Tax."
We've all paid it, and we'll all pay it again, so take some consolation from being in excellent company.
Lemony Snicket book plots notwithstanding, how do you handle your orphans?