For many of us, investing is how we save for retirement, college education and other life events. After setting our financial goals and building 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 in.
Essentially, portfolio rebalancing acts as a tune-up for your investments. It ensures your risk tolerance aligns with your long-term financial goals and gives you a chance to review the types of investments you hold.
How rebalancing works
When it comes to rebalancing, the first step is to take a look at 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 might have a higher allocation to historically risky assets like stocks or cryptocurrencies. On the other hand, a risk-averse investor might opt to have a higher weighting to less volatile asset classes like bonds or real estate.
When constructing a portfolio, the key is to understand how each asset class may impact your overall performance. By having a balanced portfolio, you are mitigating your risk of capital loss while increasing the likelihood of generating returns.
Once you determine your optimal asset allocation, there is a good chance those weightings will change as gains and losses accumulate.
Consider a portfolio composed of 60 percent stocks and 40 percent bonds at the start of the bull market in 2009. By now, that asset allocation would have changed to about 85 percent stocks and 15 percent bonds. Why? Because the stock market has significantly outperformed the bond market, up more than 450 percent from the market bottom.
For an investor close to retirement, such an asset allocation could be too aggressive, especially if the stock market were to enter a correction.
By taking the time to review and make adjustments to your asset allocation, you might also become aware of potential opportunities to buy low and sell high.
Types of portfolio rebalancing
There are various strategies for rebalancing your portfolio. The type of strategy you use depends on your investment goals and life stage.
For example, starting a family may mean you want to allocate more of your money toward a college savings account. Planning to buy a house might mean having more cash on hand for a down payment. Getting a promotion might translate to maximizing your retirement accounts.
Once you determine your financial objective, you can calibrate your portfolio accordingly.
For most investors, the most common reason to rebalance a portfolio is diversification. Through this strategy, you seek to ensure asset allocations remain consistent and in-line with your investment goals.
Another strategy for asset allocation is called “smart beta,” where you use a combination of professionally managed index funds and thematic investments.
With index funds, for example, investors are able to mimic the performance of a basket of stocks that make up an index like the S&P 500. In this case, an investor would purchase an exchange-traded fund (ETF) or a mutual fund. Through one of these investments, you gain exposure to all the stocks in that index.
Another option is thematic investing through ETFs or mutual funds. There are thousands of them tracking investment themes such as 5G technology, electric vehicles, cloud computing, cybersecurity and sustainability — to name a few.
But contrary to index funds, where fund managers follow an index, active investing is tied to a fund manager’s ability to select stocks. As a result, these types of investments tend to be more volatile.
When rebalancing a portfolio, you may opt to add a combination of index and thematic investments to your stock allocation. By employing one or both strategies, the key is to keep fees low and remain diversified.
Rebalancing for retirement
Outside of personal investment accounts, retirement accounts deserve special attention as 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 of your retirement accounts (401(k), IRA, Roth IRA), you might discover that your desired asset allocation is out of proportion.
When dealing with multiple accounts, consider consolidating all of them with an online portfolio tracker, or by keeping them at the same financial institution. Even if your accounts are actively managed, having them under one view should make it easier to track.
Target-date funds could also be advantageous for those investors who prefer a more hands-off approach. These managed funds change the risk profile based on your expected retirement age, selecting more conservative assets as you get older.
How often should you rebalance?
There is not a hard-and-fast rule on when to rebalance your portfolio. But many investors make it a habit to revisit 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.
Research from Vanguard shows there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not markedly different.
Actually, by checking your investments too frequently, you might end up making emotional decisions in the moment instead of sticking to your long-term goals. Several studies of behavioral finance reveal investors might be tempted to alter asset allocations based on market volatility instead of their financial goals.
Despite how often you check, the objective is to maintain a balanced risk profile over time.
Does rebalancing your portfolio cost money?
For the do-it-yourself investor, rebalancing a portfolio these days can be done at low or no-cost. Many brokerage firms offer no-fee trades, while low-cost options abound.
Automated investing has also made portfolio rebalancing simple. Robo-advisors automatically re-align asset allocations as part of their service based on investors’ profiles.
Many investors are still most comfortable working with a financial advisor. Of course, that personalized attention may come at a higher cost.
For retirement planning, it’s worth noting that target-date funds — mentioned earlier — usually come with a slightly higher cost than pure index funds.
Also, certain mutual funds might have early redemption fees, or even load fees. A load fee is a commission an investor pays when buying or selling mutual funds. These fees are determined by mutual fund companies and their intermediaries.
When deciding, it’s important to take note of these costs upfront. The more you can minimize unnecessary fees, the more you can invest toward your financial future.
Tax considerations when rebalancing
If you need to sell assets to rebalance your portfolio, take time to consider any tax implications.
Instead of selling, investors may also stop making new contributions to certain asset classes and redirect those funds to underweighted holdings as a way to rebalance over time. This strategy minimizes potential tax liabilities.
When rebalancing, it’s paramount to pay attention to the type of account your assets are in and the length of time you’ve owned them. These factors will determine how your capital gains or losses are taxed.
For example, rebalancing your assets in tax-advantaged accounts like a 401(k), IRA, or Roth IRA, may not incur any short- or long-term capital gains taxes. Alternatively, capital gains generated in standard investment accounts are taxed differently by the US government.
Before making any changes, you may want to consult with a tax professional.
Rebalancing your portfolio is a great way to be in tune with your finances. It ensures you remain diversified and on track to reach your long-term financial goals.
By staying engaged, you will feel more empowered to make better investment decisions and avoid potentially costly mistakes.