Time to sell the banks?

Success creates its own problems, especially in investing. That's especially true of many investors' holdings in the big banks, which frequently break one of investing's golden rules – portfolio diversification – and put at risk the huge gains made over the past decade or so.

Last week a Share Advisor member declared they had about 90% of their portfolio invested in the major banks. This may be an extreme, and extremely worrying, example, but many investors allocate more than 20% of their portfolios to the banks.

That's a worry because the miraculous performance of the big banks masks the fact that they're riskier than they've ever been.

The solution is simple: sell down your bank holdings to no more than 20% in total, with no more than 8% in any one stock. There's no need to sell all at once - indeed you might pay less capital gains tax by staggering your sales – but a 'she'll be right' attitude will only work until it doesn't.

It's time to get serious about addressing the issue you've been avoiding for too long by considering which of the following reasons you're using to hang on, and the counter-argument:

Banks have been fantastic investments. Why would I sell? Because the rear vision mirror won't tell you anything about the future and, for the banks at least, the clouds are gathering. The economy is likely to slow (at best), the banks have a large exposure to mortgages, Australian consumer debt levels are high by historical standards and bad debts are at or near record lows. Meanwhile, bank share prices look expensive. It's a good time to sell down.

Bank stocks might keep going up. Nobody wants to miss out on even larger capital gains but regret aversion – the fear you might be wrong – leads to inaction. Weigh up the risks rationally, make a decision, resolve to accept it and act.

Banks look cheaper than other stocks. Bank price-earnings ratios are traditionally 10%-25% lower than the market average (the discount is currently around 9%) because banks are far riskier than most stocks. Owning a bank is a bit like taking out a mortgage for 95% of the value of your house, then re-borrowing the increase in value each year. That's fine while house prices are rising but a real danger if they fall. Banks may look cheaper than other stocks but they're expensive when you consider the risks they face.

Bank stocks have high yields and I need the income. Higher yield implies higher risk. Even during the global financial crisis – from which Australian banks emerged unscathed – dividends were cut by around 25%. A local recession could result in capital raisings and a permanent reduction in dividends. Why take the risk?

Australia's economy is strong. Australia hasn't experienced a recession in 23 years so it's no wonder banks have prospered. But they suffer enormously during economic downturns. Twenty-two years ago in the wake of the last recession Westpac came close to collapse after writing off $2.7bn in bad debts. Two decades of uninterrupted growth has caused investors to forget the fact that banks are cyclical, highly-leveraged businesses.

Australian banks are too big to fail. The Australian government would probably rescue the banks (at the cost of a major recession) but depositors would be saved, not shareholders. Between 2007 and 2009, the share prices of major British, American, Irish and Icelandic banks fell by more than 90% before they were nationalised. The government will save the banks, not your investment.

My capital gains tax bill will be too large. A portion of any gain you make has belonged to the government since the introduction of capital gains tax in 1985. Paying tax is the mark of a successful investment. Don't let tax consequences drive your investment decisions.

What would I buy with the proceeds? There are 29 stocks on our Buy list and our model portfolios have outperformed the market with negligible bank exposure. You don't need to own the banks to do well. Nor do you need to reinvest any sale proceeds immediately. There's nothing wrong with waiting for the right opportunity. Our long-term recommendation to buy stocks with international exposure – or international stocks themselves – will insulate your portfolio should the worst eventuate.

Let's now assume you are over-exposed to the banks and have decided to sell down. How can you minimise the tax consequences?

Making tax-deductible superannuation contributions might be one way. If you own your bank shares in a superannuation fund, converting it to an allocated pension is another. Why not investigate these strategies with your accountant or advisor?

A simpler strategy – and one you can implement over the next few weeks – is to stagger your sales over two (or more) financial years. This takes advantage of the 50% capital gains tax discount applicable to investments held for more than a year in an individual's name and works best for those on low-to-average marginal tax rates.

Let's assume you bought 2,000 shares in Commonwealth Bank at $30 a share in 2004. At around $80 a share now your holding is worth $160,000 and represents more than 30% of your portfolio.

You decide to sell 400 shares now, and another 400 shares in July to bring the holding down to less than 20% of your portfolio. Unless your income is well under the tax-free threshold of $18,200 a year, you will pay some capital gains tax but it won't be an outrageous sum (and will depend on your marginal tax rate).

You could, for example, earn up to $70,000 a year in other income, sell 400 CBA this financial year and next, and lose only 16% of your sale proceeds in capital gains tax.

None of this is to predict a banking crisis but the GFC proves that banks can and do fail. Statues might belong on pedestals but banks certainly don't. A sensible weighting of no more than 20% to Australian banks will keep your portfolio on a solid footing. Don't let past success blind you to the risks of having too much tied up in bank stocks.

Nathan Bell is Research Director of Intelligent Investor Share Advisor (AFSL 282288).