Year-End Capital Gains Need Not Be All Bad News.

SHOULD your favorite mutual fund hit you with a hefty capital gains distribution in the next few weeks, don't whine or worry. Turn it to some positive use.

Now there's an offbeat idea in this age of being aggrieved -- pass up a chance to protest. It calls to mind the corny but cogent aphorism, "When life hands you a lemon, make lemonade."

For a suggestion on how to follow that advice with those oh-so-taxable year-end gains distributions, we turn to Sheldon Jacobs, publisher of the No-Load Fund Investor newsletter in New York.

"Distributions will be heavy this month and next," Jacobs says in the November issue of the letter, noting that many funds sold stocks amid the storms of the 2000 market, realizing big gains built up in previous years.

The rules say that the funds must pass through any net gains to shareholders by year-end.

Except in tax-deferred setups such as employer-sponsored 401(k) plans and individual retirement accounts, investors will face a tax bill on these gains even if they automatically reinvest their distributions in new fund shares.

Here's where Jacobs' positive response kicks in: Instead of having this year's gain reinvested, as most investors routinely do, instruct your fund to pay it to you in cash.

"A phone call is generally sufficient," Jacobs says. "The tax on the distribution is the same whichever alternative you choose."

Once you have received your check or, perhaps more conveniently, had the distribution paid into your money-market fund, there are several useful things you can do with it.

Avenues for cash

The first to consider is rebalancing, or bringing the asset allocation of your investments back closer to your original intentions. Let's say you started out five years ago with a plan to keep 65 percent of your money in stock funds and 35 percent in money funds. Now, after stocks' great bull run of 1995 through early this year, the weighting of your holdings is more like 80-20.

To this point you've resisted rebalancing out of inertia and an unwillingness to deal with the tax consequences of shifting money out of stocks. Well, the year-end distribution gives you a sum to work with that's going to be taxed anyway.

It's probably not the precise amount that your asset allocation model calls for.

Unless you have some fiduciary committee looking over your shoulder, though, that's not so important. A partial rebalancing may serve you much better than no rebalancing at all.

That basic idea opens up other possibilities. Let's say I have accumulated a good-sized position in a fund that set a dazzling pace in years gone by, but has now slowed and grown too big for my taste.

I can take the distribution and put it in a newer, smaller fund I've had my eye on, starting to diversify out of the old fund without incurring any taxes I wouldn't have had to pay anyway.

Added bonus: The paperwork will be minimal, and I won't have to trouble myself or run up time on my accountant's meter deciding which of several possible tax treatments to use if I sold part of my shares in the old fund. Unlike many other capital gains, fund distributions are simple to account for on your tax return.

Not tax money

This money, I remind myself, is not for spending. Another thing I wouldn't do with the distribution proceeds, unless my finances left me no choice: Set the money aside to pay taxes.

I realize, it makes no difference from which of my accounts I write the check to Uncle Sam.

In practice, however, I am not a money-management automaton. Many a distraction may arise between the moment a dollar gets into my cash flow and the time when it's safely diverted to savings and investment. If I can leave my investment accounts undisturbed and pay the taxes out of current funds,

I forestall the possibility that I won't get around to making up the difference in my nest egg.

The idea behind all these tactics is to prevent taxes from disrupting your investment plan any more than necessary. Going with the flow this way may not make gains distributions seem like a blessing instead of a burden, but it can take some of the sting out.

Chet Currier is a columnist for Bloomberg News.

Diversification Is Saving the Day for Investors

Look what's turning out to be the cardinal virtue of investing in 2000: That old dullard diversification.

You remember diversification. It was the fun-killer of the 1990s, loading your portfolio with baggage that kept it from soaring on the wings of the New Economy. By last year, it seemed everyone you talked to was urging you to pitch it overboard.

Now, a year later, the ballast has become a blessing. The average stock fund has lost money since the start of 2000; so has the average high-yield bond fund.

The gains for investors this year have been concentrated in the safest, no-excitement choices -- the likes of government bond funds and money funds.

Diversification, by definition, is never a recipe for maximizing the return on your investment. The purpose that diversification serves is to provide an adjustable tool for managing risks, such as the ones that have manifested themselves this year.

These risks always exist, to an unknown degree, whether you acknowledge them or not.

If you listen to serious investors like Bob Stansky, manager of the $104 billion Fidelity Magellan Fund, there's a strong argument for keeping an element of caution in your investment plan now.

"The strong results of the past several years were historical anomalies," Stansky said the other day in Magellan's semiannual report to investors. "I think a slowdown in the economy is likely. At the same time, we may see a broad slowing of corporate earnings growth."

If you listen to serious investors like Bob Turner, chairman and chief investment officer of Turner Investment Partners, which manages $11 billion with an emphasis on high-tech stocks, there's also a strong argument for keeping an element of optimism in your investment plan.

"We think the worst may be over and a rally is a distinct possibility over the next few months," said Turner in an advisory published this month. "The fundamentals remain favorable, and the bad news is by and large already factored into stock prices."