How to Rebalance Your Portfolio

What Is Rebalancing?

Rebalancing involves periodically buying and selling investments in an established portfolio to ensure that its asset allocation continues to fit an investor’s risk tolerance and investment objectives.

It’s recommended that investors rebalance their portfolios annually because the assets in them can shift in value during the year.

The goal in rebalancing your portfolio is not perfection, since as soon as your allocations regain their predetermined percentages, prices will shift, causing the allocations to deviate again.

The goal is simply to make sure that the balance of assets is working for you as effectively as possible.

This article provides the basics that every investor should know about rebalancing.

Key Takeaways

Rebalancing your portfolio can fine-tune its diversification to minimize volatility and risk.
To keep your portfolio balanced, start by measuring your actual allocations and compare them to your original or preferred allocations.
You can choose from several rebalancing strategies based on triggers such as time spans and percentage changes.
Rebalancing can conflict with tax loss harvesting strategies.
Consider using a robo-advisor if you find that handling rebalancing yourself is too difficult.

When you rebalance your portfolio, consider these questions:

How much has my portfolio deviated from my original asset allocation?
Am I still comfortable with my original asset allocation, or has my situation shifted, suggesting that I amend the asset mix?
Have my goals and/or risk tolerance changed, and if so, does my allocation reflect this?
Does my current asset allocation still work for me, so that my portfolio’s balance needs no tweaking?

Ways to Rebalance Your Portfolio

There are several rebalancing strategies:

Select a percent range for rebalancing, such as when each asset class deviates 5% from its asset weight. The window of drift tolerance can be as low as 1 or 2% or higher than 5%. It all depends on your tolerance and the time you’re willing to dedicate to keeping the portfolio compliant with the set allocation.
Set a time to rebalance. Once a year is sufficient, although some investors prefer to rebalance quarterly or twice per year. There’s no wrong or right strategy, although less frequent rebalancing will potentially lead to greater stock allocations and higher overall returns, along with greater volatility.
Add new money to the underweighted asset class to return the portfolio to its original allocation.
Use withdrawals to decrease the weight of the overweight asset. If stocks have increased 1%, sell a portion of the overweight stocks and withdraw the proceeds.

It’s recommended that younger investors devote a greater percentage of their portfolios to stocks and a smaller percentage to fixed income securities. Although stocks are a higher risk investment, they offer a greater return over time due to capital appreciation and, potentially, dividend income. Those with years to build their savings can afford to invest aggressively because they have the time to recover from stock market losses that they may incur.

Steps to Rebalance Your Portfolio

Generally, you should track the asset allocation of your portfolio over time so that you can determine when it changes. You can maintain your records on a spreadsheet or use a free or paid investment monitor like Quicken or Mint.

Once you’ve listed your assets and the percentage devoted to each asset class is recorded, you can rebalance when needed.

Step 1: Compare

Compare the current asset values and weight percentages of each asset class with your predetermined (or newly desired) asset allocation.

Step 2: Assess

Notice the difference between your actual and preferred asset allocation. If your 80% stock, 20% bond portfolio has drifted to 85% stocks and 15% bonds, then it’s time to rebalance, either by adding new money or selling stocks and buying bonds.

Step 3: Sell

Assume your portfolio is worth $100,000. Given the drift above and a desired 80%/20% balance, to reduce your percentage of stocks by 5%, you’ll sell $5,000 worth of stock investments.

Step 4: Then Buy

With the $5,000 proceeds from the stock sale, you’ll buy $5,000 of bonds. This will return your portfolio to its preferred 80%/20% mix.

Step 5: Add Funds

Let’s say that you decide to add $10,000 to your portfolio. Its value would then be $110,000 and the desired 80%/20% asset mix would now require $88,000 in stocks and $22,000 in bonds.

(Multiply $110,000 by 80% for the stock allocation and $110,000 by 20% for the bond allocation to arrive at these dollar goal amounts).

Step 6: Then Invest Those Funds

Recall that you currently have $85,000 in stocks and $15,000 in bonds. To achieve the 80%/20% balance desired (which requires $88,000 in stocks and $22,000 in bonds), invest $3,000 of your added cash in stocks and $7,000 in bonds.

Follow these steps every time you rebalance your portfolio. Don’t worry if the asset allocation drifts between your rebalancing periods. If your situation changes, and you become more conservative on the one hand or more comfortable with greater volatility or risk on the other, you can always adjust to a newly desired asset allocation.

How to Use a Robo-Advisor to Rebalance Your Portfolio

A robo-advisor might can be a great solution for those who prefer to outsource portfolio selection and rebalancing.

Robo-advisors such as Wealthfront and Schwab Intelligent Portfolios are designed to offer investors access to well-diversified investment portfolios, rebalancing, and other features, such as tax loss harvesting, with low or no management fees.

The most popular robo-advisors administer a quick survey to determine your investment goals, timeline, and risk. This survey drives the makeup of your investment portfolio.

After investing, robo-advisors will rebalance your holdings on an as-needed basis, to keep your it in line with the initial survey parameters.

Pros and Cons of Portfolio Rebalancing

Investment management, which involves rebalancing, requires a commitment. You’ll need to analyze your investments to make certain that they continue to meet your objectives.

You might choose to increase the stock allocation if you’re comfortable with greater risk. Or, you may want to increase the fixed income allocation to preserve capital if you’re nearing retirement or are uncomfortable with occasional double-digit declines in your portfolio’s value.

Pros

Updates and improves a portfolio’s diversification
Reduces a portfolio’s volatility and risk
With planned rebalancing, you’re less likely to become spooked at a market drop and sell at the bottom

Cons

Can reduce exposure to outperforming sectors and increase exposure to underperforming sectors
May conflict with tax loss harvesting strategies
Requires time and effort to understand, select, or alter your own investments

Additional Tips to Rebalance Your Portfolio

Here are additional tips to aid in successful rebalancing:

Avoid checking your investment values too frequently (such as daily or weekly). You might feel the need to act, which typically leads to overtrading and inferior investment returns.
If you didn’t when you originally built your portfolio, create a personal investment policy statement or investment plan, which includes your investment mix, asset allocation, and rebalancing parameters. Stick to it.
Minimize tax events generated by taxable accounts. This involves tax loss harvesting (selling losing positions to offset capital gains).
Maintain a long-term focus to reach your long-term goals. Don’t be distracted by changes in the value of your investments.

Remember that investing is how you can turn today’s earnings into future financial security.

Investing and rebalancing are designed to increase your returns over time, such as five or more years. For shorter-term goals, consider a certificate of deposit or high-yield money market account.

Why Should I Rebalance My Portfolio?

You should rebalance your portfolio periodically so that your holdings (e.g., equities and fixed income securities) continue to meet your financial goals and match your risk profile. Investment values change, which means that the percentages that investments represent of your overall portfolio can change. If you don’t rebalance and restore your assets to the appropriate balance of, say, a 80% vs. 20% stock/bond mix, then you might open yourself up to greater risk of financial loss than you’re comfortable with. Rebalancing helps your investments stay on track to meet your financial goals.

How Much Does It Cost to Rebalance a Portfolio?

Most investment brokers don’t charge commissions or trading fees for stocks and ETFs. So buying and selling stocks and funds is typically fee-free. If you own individual bonds, you’re apt to pay a commission to buy or sell. Mutual funds might also levy a fee to trade.

As long as you’re buying and selling stocks or ETFs, the only cost you might incur is a tax on a capital gain, if it’s realized in a taxable brokerage account.

Can I Rebalance My Portfolio Without Selling?

Yes, you can rebalance your portfolio without selling. Add new money into the portfolio and buy the asset class that is underrepresented. If you need to withdraw funds from your account, sell a portion of the overrepresented asset. You can also reinvest cash dividend payments into an under-allocated asset class.

Does Portfolio Rebalancing Reduce Returns?

Rebalancing reduces returns in most cases. Historically, stocks have provided a greater return than bonds, so they’ll become a greater percentage of the total portfolio over time without rebalancing. When you rebalance and sell some stocks, you’ll reduce your portfolio’s return. But bear in mind that stocks are riskier than bonds, so as the percentage of stocks in your portfolio grows, so does your risk. Rebalancing is usually a tradeoff between greater return and lower risk.

How Often Should I Rebalance My Portfolio?

Rebalancing too frequently can sacrifice returns while rebalancing infrequently can increase portfolio risk. Vanguard recommends checking your portfolio annually. The key is to set up and stick with a rebalancing schedule that works for you.

The Bottom Line

Rebalancing will maintain your preferred asset allocation and help to smooth out the volatility of your portfolio.

When stock prices soar, rebalancing will force you to take some profits. When prices are lower, and an asset class declines in value, you’ll buy at lower levels.

Less frequent rebalancing saves you time and might allow your winning assets to grow for a bit longer.

Source link

Barbara A. Friedberg

What Is Rebalancing?

Key Takeaways