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For many of us, investing is how we save for retirement, college education and other life events. Once we set our financial goals and build a diversified portfolio, we can watch our investments grow over time. But as the years go by and situations change, we may need to adjust those investments. That’s where portfolio rebalancing comes into play.
Essentially, portfolio rebalancing acts as an alignment with your investments. It ensures that your risk tolerance matches your long-term financial goals and gives you a chance to assess the types of investments you hold.
How portfolio rebalancing works
When it comes to rebalancing, the first step is to review your asset allocation.
Asset allocation is the mix of investments you own, such as stocks, bonds, funds, real estate and cash. This asset allocation takes into account your risk tolerance and financial goals.
Someone who is more risk tolerant may have a higher allocation to historically risky assets such as stocks. On the other hand, a risk-averse investor may choose to have a higher weighting in less volatile asset classes such as bonds or real estate.
When building a portfolio, it’s important to understand how each asset class can impact your overall performance. By having a balanced portfolio, you reduce the risk of capital loss and increase the chance of returns.
Once you determine your optimal asset allocation, it’s likely that these weightings will change as some investments perform better than others.
Consider a portfolio that consists of 60 percent stocks and 40 percent bonds at the beginning of a bull market. Over time, that allocation will shift as stocks outperform bonds. If you make no adjustments, you can end up with a portfolio of 80 percent stocks and 20 percent bonds.
For an investor nearing retirement, such asset allocation may be too aggressive, especially if the stock market experiences a prolonged bear market.
By taking the time to assess and adjust your desired asset allocation, you can manage the risk of your portfolio and potentially buy low and sell high.
Types of Portfolio Rebalancing
There are generally two different ways to approach portfolio rebalancing:
- Rebalance agenda: A calendar rebalancing strategy involves assessing your portfolio at certain times during the year to determine whether rebalancing makes sense. This can be monthly, quarterly or annually.
- Activate rebalancing: A trigger rebalancing strategy is when you rebalance your portfolio whenever the allocations have drifted a certain amount from your desired allocation. For example, you can choose to rebalance the balance once the allocations deviate by five percent or more from the desired amount.
There are pros and cons to each approach, so you’ll want to think about which one makes the most sense for you. A calendar-based approach is quite simple but can lead to rebalancing more often than necessary, while a trigger-based approach requires regular monitoring and can lead to frequent rebalancing in volatile markets.
The importance of rebalancing a portfolio
Markets change, which means your portfolio must change too. Failure to do so could result in losses you may not have expected.
The return will fluctuate, as will its weighting in your portfolio. For example, investments that were once considered safe may become speculative within a few years, and you will need to adjust accordingly to maintain your desired allocation.
An investment you once considered low risk and owned, say, 20 percent of your portfolio, could become risky within five years. Your weighting must then be adjusted to a lower amount.
If you believe in the long-term value of certain investments and have a long time horizon, holding on might not be a bad idea. However, if you hold certain investments with the intention of maintaining a low risk profile, you will likely need to rebalance your portfolio to reflect market movements.
Depending on what your investment goals are, not rebalancing your portfolio could cause you to incur significant losses that you may not be prepared for. It is important to continually monitor your portfolio and the status of your investments.
How often do you need to rebalance?
There is no hard and fast rule about when to rebalance your portfolio. But many investors make a habit of reviewing their investment allocations annually, quarterly, or even monthly. Others decide to make changes when an asset allocation exceeds a certain threshold, such as 5 percent.
Vanguard research shows that there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not materially different.
If you check your investments too often, you may make emotional decisions in the moment instead of sticking to your long-term goals. Several studies in behavioral finance show that investors may be tempted to change asset allocation based on market volatility rather than their financial goals. No matter how often you check, the goal is to maintain a balanced risk profile over time.
Does rebalancing your portfolio cost money?
For the do-it-yourselfer, portfolio rebalancing can now be done at little or no cost. Many brokerage firms offer commission fee trades, while there are many low-cost options.
Automated investing has also made portfolio rebalancing easy. Robo-advisors automatically rebalance asset allocation as part of their service, based on investor profiles.
Many investors still feel most comfortable working with a financial advisor. Of course, that personal attention can entail higher costs.
In terms of retirement planning, it’s worth noting that target date funds adjust their portfolios over time as the fund gets closer to the target date. Although target date funds tend to have slightly higher costs than pure index funds.
Certain investment funds may also charge early redemption fees or even loading fees. A loading fee is a commission that an investor pays when buying or selling mutual funds. These fees are determined by investment funds and their intermediaries.
When deciding, it is important to take note of these costs in advance. The more you can minimize unnecessary costs, the more you can invest in your financial future.
Tax considerations when rebalancing
If you need to sell assets to rebalance your portfolio, take the time to consider any tax implications.
Instead of selling, investors can also stop making new contributions to certain asset classes and divert these funds to underweight positions as a way to rebalance over time. This strategy minimizes potential tax liabilities.
When rebalancing, it is paramount to pay attention to the type of account your assets are held in and the length of time you have owned them. These factors determine how your capital gains or losses are taxed.
For example, if you rebalance your assets into tax-advantaged accounts such as a 401(k), IRA or Roth IRA, you will not be subject to capital gains taxes in the short or long term. Alternatively, capital gains generated in standard investment accounts are taxable by the U.S. government.
Before making any changes, it is best to consult a tax advisor.
Rebalancing for retirement
Outside of personal investment accounts, retirement accounts deserve special attention because your age will primarily determine how assets should be allocated.
The principles and strategies for rebalancing a portfolio are essentially the same. However, by taking a holistic view of all your retirement accounts (401(k), IRA, Roth IRA), you might discover that your desired asset allocation is out of proportion.
If you’re dealing with multiple accounts, consider consolidating them all with an online portfolio tracker, or keeping them at the same financial institution. Even if your accounts are actively managed, it should be easier to keep track of them in a single view.
Target date funds can also be beneficial for investors who prefer a more hands-off approach. These managed funds change the risk profile based on your expected retirement age and select more conservative assets as you age.
In short
Rebalancing your portfolio is a great way to stay on top of your finances. It ensures you stay diversified and on track to achieve your long-term financial goals.
Consider rebalancing your portfolio regularly or when your portfolio deviates too far from your desired allocations. This will help tailor your portfolio to your objectives and risk tolerance.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
