Paying attention to the makeup of your investment portfolio helps you keep track of your allocations. When your target assets are off, you rebalance to keep your portfolio healthy and diversified. There’s no need to be an expert investor to put this plan into practice. Instead, you simply need to set a schedule to review your portfolio and execute the rebalancing process.
Here’s what you need to know about when to rebalance and why you should.
Portfolio Rebalancing Explained
Most portfolios contain a mix of stocks and bonds. The amount you hold in each category should reflect your preferred risk tolerance for where you are in your life. This refers to your target asset allocation, which is defined by certain percentages in different types of investments.
An example would be holding 75% in stocks and 25% in bonds. If your stock investments grow significantly (as you hope they do), you may want to occasionally rebalance. When growth occurs in this scenario, it could cause your stock holdings, for instance, to be closer to 80 or 90%. In that case, you’d want to shift some of your stocks to one of your more conservative investments like bonds. This process is called rebalancing.
How to Rebalance
To rebalance your portfolio, you need to sell some of your holdings that are out of balance and replace them with underperforming holdings. In short, you’re selling the stocks that grew in value and replacing them with a lower-performing asset class that is now under-represented in your portfolio.
It may seem counterintuitive to trade in some of your stronger stocks in favor of weaker ones, but it’s based on the old investment adage of “sell high, buy low.” In order to rebalance effectively, however, you need to have a target allocation in mind, rather than just investing on a whim. With a set strategy in mind, you’ll know exactly when you’re off track so you can rebalance at the right time. For a DIY investor who’s not entirely sure how to start, there are plenty of free online tools that offer asset allocation recommendations based on your financial situation and future goals.
If you work with a financial advisor or planner, they may or may not analyze your portfolio on your behalf. In many cases, they may only perform a review on a quarterly or even annual basis. Get clarity on just how much oversight is being done because rebalancing may not actually be part of the services they offer.
When you invest through a robo-advisor or hybrid online platform, rebalancing may be done automatically when your portfolio moves outside of its target range. Alternatively, it may happen on a set schedule throughout each year. How and when rebalancing occurs may be a deciding factor when choosing the best robo-advisor to invest with.
Finally, you can also initiate trades to rebalance on your own by monitoring your portfolio on a regular basis. With any rebalancing strategy, make sure you look at all of your accounts holistically, especially if they’re spread out over taxable accounts, IRAs, and 401(k)s. If you’re married, you may also want to look at both spouse’s accounts and collectively check your asset allocations.
Pros and Cons of Rebalancing
The point of rebalancing is to strengthen your portfolio. The process comes with distinct advantages, but also a few disadvantages to be aware of. Weigh both so you can decide the best time to rebalance based on your individual investment goals.
A primary reason to rebalance is to keep your target allocation in check and avoid overexposure to risk. As one area of your portfolio grows, you’re at a higher risk of losing more money if that position experiences a major drop. Shifting that money into less volatile assets like bonds or cash can reduce the risk of loss.
But rebalancing isn’t just about playing it safe. Another benefit is that you could set yourself up for better long-term growth. By buying lower-performing assets at a bargain price, you have more potential to increase your portfolio’s value over time. This isn’t always the case, but sometimes rebalancing can help you get bargain prices on certain investments.
There are a few downsides to rebalancing that you need to consider in order to maximize the positive impact on your portfolio. One is the cost of trading fees and/or commissions every time you sell a position. This can get particularly expensive if the market is volatile and you decide to frequently rebalance your portfolio. If you invest in mutual funds, you may also experience both entry and exit fees so make sure you understand the full cost of any trade you plan to make.
Another downside of rebalancing is that you’ll owe capital gains tax when you trade anything in a taxable investment account. When possible, it may be better to rebalance in a tax-sheltered account like an IRA. You can also minimize taxes by selling stocks that you’ve held for more than a year, since those are taxed as long-term capital gains and hold a lower tax rate than short-term gains.
A final disadvantage of rebalancing your portfolio is that you could potentially miss out on more profits from the strong stocks you sell. Investing always includes some type of risk, whether by losing what you put in or losing the chance to make even more.
When to Rebalance Your Portfolio
There are many strategies you can choose from to figure out when to rebalance your portfolio. One maxim is to rebalance when any single asset allocation changes by 5% or more, whether from increasing or decreasing in value.
It’s also smart to set a schedule for reviewing your portfolio assets, whether monthly, quarterly, or annually. Avoid getting obsessive and rebalancing your investments too frequently. While it’s certainly smart to track the progress of your portfolio on a regular basis (even more than monthly, if you’d like), you can easily start to drain your account if you over-do it and rebalance too frequently.
You should also reconsider the makeup of your portfolio as you get older. When you begin to near retirement age, most experts recommend shifting your investments so that the majority of your holdings are less volatile. You won’t see your balance grow as aggressively as it may have in the past, but you’ll have more stability, especially if you’re close to making retirement withdrawals.
Another potential time to rebalance is when you experience a loss in your portfolio. Many robo-advisors incorporate tax-loss harvesting into your strategy. It involves selling a stock at a loss in order to minimize your overall gains (and therefore, your tax liability). You can then replace it with a similar (but not “substantially identical”) position, and even repurchase the initial stock 30 days later. It’s possible to manually implement tax-loss harvesting when rebalancing your portfolio, but there are many IRS rules you must abide by.
When Not to Rebalance Your Portfolio
It’s not always necessary to rebalance your portfolio. When thinking about how frequently you check your progress (such as quarterly or annually), remember that you don’t need to actually initiate a rebalancing. You may find that your asset allocations are still on target and there’s no need to make a change. Minor fluctuations are fine and to be expected.
During volatile market phases, rebalancing too frequently can also cause you to miss out on returns over time. Much of this depends on how close you are to actually using the money you’ve invested. Additionally, rather than selling positions, you may instead choose to adjust how your new deposits are allocated.
If you’re not sure how to manage these market swings, it may be worth the time and money to either get advice from a financial advisor or put your money into a robo-advisor that automates the rebalancing process.
Finally, remember to avoid rebalancing target-date funds when looking at your portfolio allocations. These funds are designed to automatically rebalance at specific times. Popular in 401(k) accounts, you can pick one based on the age at which you plan to retire and they already hold a mix of asset classes that change as you get older. If you rebalance a target-date fund, you’re basically interfering with a premeditated strategy to decrease your risk over time.
The Bottom Line
Choosing to rebalance your portfolio hinges upon knowing your investment goals and having a clear strategy to reach them. Setting guidelines for yourself helps to take the emotion out of making a decision and instead makes it a mathematical process.
For investors who aren’t comfortable taking the plunge to rebalance on their own, you might benefit from using a robo-advisor or human financial advisor to help you weigh the pros and cons. No matter what type of portfolio management style you choose, make sure to create a regular review process. That way, you can rest easy knowing exactly how your investments are performing, whether you choose to rebalance or not.