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In the world of financial markets and investment portfolios, there is no shortage of strategies, philosophies, tips, and tricks. However, one strategy that should be in every investor's toolkit is portfolio rebalancing, which can help you navigate the changing tides of the markets and help you stay on course toward your ultimate goals.
With the S&P 500 near all-time highs, now may be a good opportunity to review your portfolio to determine if you’re due for a rebalance. In this article, we’ll discuss how portfolio rebalancing works, strategies to consider, and best practices.
What is Portfolio Rebalancing?
When you initially design your investment portfolio, you create an asset allocation that aligns with your risk appetite and investment objectives. This “asset allocation” is simply your targeted mix of investments, such as stocks and bonds. For instance, an investor with a “60/40” portfolio would have an asset allocation that is 60% in equities (stocks) and 40% in bonds.
However, as market conditions fluctuate, the value of your investments will change, which may cause your portfolio to deviate from its original allocation. Rebalancing involves adjusting these allocations back to their original levels by selling a portion of an investment that’s over its target allocation and buying additional shares of an investment that is below its target.
Benefits of a Portfolio Rebalance
Risk Management: The primary goal of rebalancing is to control risk and reduce volatility (swings in value). Different asset classes have varying degrees of risk and volatility. For instance, equities typically carry higher risk and exhibit larger swings in value compared to bonds, but have the potential for higher returns. If equities perform exceptionally well over a period, and outperform other investments in your portfolio, they will make up a larger portion of your portfolio. This increases the overall risk of the portfolio and potentially subjects you to fluctuations in portfolio value that you are unwilling to tolerate. By regularly rebalancing, you ensure that your portfolio doesn't become too heavily weighted towards a particular asset class that may be experiencing temporary gains. This keeps volatility at a level that is aligned with your appetite for risk.
Opportunity Capture: We all know the age-old adage of “buy low sell high,” but the unfortunate reality is that many investors buy high and sell low (you can read my article about market timing here). Additionally, no investment goes up in a straight line as there is an ebb and flow to the performance of any investment.
Portfolio rebalancing is a systematic process that takes advantage of fluctuating values by buying shares of underperforming assets (buying low) and selling shares of outperforming assets (selling high). It’s a repeatable process for buying low and selling high and doesn’t rely on emotions or gut feelings. Over time, this can potentially lead to improved returns while maintaining a consistent level of risk.
When to Rebalance Your Portfolio
Want to overwhelm yourself with information? Start reading technical papers on optimal rebalancing strategies (I read them, but it’s my job). Suffice it to say, there are many, but most revolve around two main strategies.
Time-based: Under this approach, portfolios are rebalanced at regular intervals, such as monthly, quarterly, semi-annually, or annually. This approach is straightforward to implement, but as frequency increases, so do transaction costs, tax implications, and time commitment.
Threshold-Based: Using this approach, time intervals are irrelevant, and the portfolio is rebalanced only when an asset class’s allocation deviates from its target by a certain percentage. Common threshold limits are 5% and 10%.
For example, let’s say you have 60% of your portfolio allocated to stocks and you want to rebalance based on a 5% threshold. In this instance, you would only rebalance if stocks make up more than 65% of your portfolio or less than 55% of your portfolio. This method typically reduces the frequency of trading and generally requires trades only after large moves in asset class prices. However, it does require that you monitor your portfolio regularly.
Combining Strategies: A third option is a combination of the two strategies where your portfolio is reviewed at regular intervals (quarterly, semi-annually, etc.), but changes are only made if investments are off by a predetermined threshold. Essentially, the time element and threshold element must align
What's the Best Strategy?
The answer to this question depends on your investment goals, investment strategy, risk tolerance, and how much time you want to commit to the endeavor. However, the following are some best practices:
If you aren’t working with an advisor, keep it simple. The more involved the process, the less likely you are to follow through year after year. Consider monitoring your portfolio one to two times a year for a potential rebalance. Some investors do this at the end of the year while others might use their birth month. If you work with an advisor, ask them how they rebalance your portfolio so that you understand their methodology.
Ignore the “noise,” which means sticking to a rebalancing schedule regardless of what is taking place in the financial markets. Rebalancing poses challenges for some investors who find it difficult to sell or trim back on investments in a bull market, and potentially more difficult to purchase shares when prices are dropping such as in a bear market. If you find yourself second-guessing your plan, just remember the words of Warren Buffet who says, “Be fearful when others are greedy, and be greedy when others are fearful.” This sounds like good advice for someone who wants to buy low and sell high.
Although many brokerage firms offer commission-free trading and no-load mutual funds, make sure to account for any transaction costs associated with rebalancing your portfolio such as commissions or mutual fund redemption fees.
Rebalancing your portfolio can create long-term and short-term capital gains, so make sure you understand the tax implications of your trades. Consider incorporating a tax-loss harvesting strategy to mitigate capital gains taxes, which you can read about here.
If you are regularly adding new money to your accounts, such as an IRA or taxable brokerage account, you can use the new cash to purchase shares of investments that are below their target allocations. This might alleviate or eliminate the need to sell shares of investments that might be over their target allocation.
Many investors have the bulk of their investments in a retirement plan such as a 401(k). Most 401(k) custodians offer a feature that will rebalance your portfolio automatically based on the criteria you select.
If your investment portfolio is spread across many accounts such as a 401(k), Rollover IRA, Roth IRA, and taxable brokerage accounts, rebalancing can create challenges. Ideally, all your accounts will be synchronized and working in unison to hit your overall target allocation and tax strategy, so crunching the numbers and rebalancing across multiple accounts (and potentially multiple custodians) can be complicated and time-consuming. Consider working with an advisor who understands the nuances of each account type and can help you optimize the process.
Conclusion
While rebalancing your portfolio involves some effort, the strategy is a key component of the investment management process. By maintaining a disciplined approach and periodically reviewing your asset allocation, you can ensure that your investments stay on track to meet your financial goals, maintain your desired level of risk, and potentially enhance your long-term investment performance.
However, the key to effective rebalancing lies in a well-defined investment plan and a disciplined approach. Make sure you have a thorough understanding of your investment goals and investment strategy, and that you understand the tax implications of your financial decisions. If you are unsure about the intricacies of portfolio rebalancing or the tax implications, you should speak with a tax or investment professional who can help you make informed decisions.
Tad Jakes, CFP®, EA
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