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Investing isn’t as simple as building a portfolio and just setting it on autopilot until retirement. You should be checking in on your investments from time to time for tune-ups, which investment pros call portfolio rebalancing.
Rebalancing your portfolio means buying and selling assets to help maintain the right level of investing risk you’re comfortable with. This not only keeps you on track to meet your goals, but it may also enhance your portfolio’s returns.
What Is Portfolio Rebalancing?
When you start investing, you begin by outlining your goals and choosing an asset allocation strategy to guide your purchases. This strategy balances the potential for high returns against the amount of risk you’re comfortable with. You’ll likely be buying both stocks to fuel growth and high returns, plus bonds for stability and income.
A long-term investment portfolio for retirement, for example, might have an asset allocation of 80% stocks and 20% bonds. But not all stocks are the same: The 80% in stocks might be subdivided into U.S. large company stocks, U.S. small company stocks and international stocks. Likewise, bonds may be divided between U.S. government bonds and corporate bonds.
As the investments that make up the portfolio change in value, the portfolio can drift away from your chosen asset allocation. While the plan might have been to invest 80% in stocks and 20% in bonds, for instance, that allocation made drift to 85% stocks and 15% bonds based on market returns, as the bonds you’ve purchased lose value and the stocks gain in value.
Rebalancing involves buying and selling mutual funds, exchange-traded funds (ETFs) or other investments to bring a portfolio back to its planned asset allocation. Continuing the example above, you would sell 5% of your portfolio’s value in stock holdings and use the proceeds to purchase bonds. This would bring the portfolio back in line with the planned asset allocation of 80% stocks and 20% bonds.
Why You Need to Rebalance Your Portfolio
Rebalancing is important for two reasons: risk management and improved returns.
An asset allocation plan is designed to accomplish two competing goals: optimal returns and minimal risk. Without rebalancing, many portfolios drift away from bonds and into more stock investments over time. While this could increase the long-term returns of the portfolio, it will also add significant risk. This may, for example, make your portfolio’s highs higher and lows much lower. Depending on your timeline, goals and ability to handle potential short-losses, this greater level of risk may derail your financial plans.
In addition to keeping your risk in check, rebalancing can actually improve your investing returns when you rebalance two or more asset classes that have similar long-term expected returns.
Rebalancing between small company funds, emerging markets and REITs, for example, may enhance your returns as you sell one that is performing well to buy more of another that is performing poorly now but has historically offered similar returns. In that case, you might be selling high and buying low, the ultimate goal with investing.
When Should You Rebalance?
There are two general approaches to how often you should rebalance your portfolio. The simplest approach is based on time. You might rebalance your portfolio once a quarter, once every six months or perhaps once a year. In addition to simplicity, this approach removes psychological factors that can cause investors to make changes in their portfolio during extreme market fluctuations.
The second approach—one recommended by many financial advisors—is to rebalance based on tolerance thresholds. For example, you might rebalance an asset class when its allocation deviates from the planned allocation by 20% or more.
Let’s assume a hypothetical asset allocation plan includes 10% in small-cap companies. Twenty percent of this allocation is 2%. If you use a tolerance threshold, you’d rebalance when the small-cap asset allocation dropped below 8% or above 12%. In either case, the asset class would have drifted from the plan allocation by 20%. If an asset class comprised 50% of a portfolio, you would rebalance when that asset class dropped below 40% or above 60%.
Using tolerance thresholds to rebalance a portfolio has several benefits. First, it’s an objective standard that, similar to a time-based approach to rebalancing, removes investors’ emotions from the decision. Second, it rebalances based on the actual performance of a given asset class, not an arbitrary time period. Finally, at least one study has shown that using a 20% tolerance threshold for rebalancing asset classes with similar expected returns can enhance the return of the portfolio.
How Do You Rebalance an Investment Portfolio?
The steps to rebalancing an investment portfolio are straightforward. First, identify those asset classes that have deviated from the planned allocation. If you’re using a tolerance threshold, you need to determine if an asset class has deviated enough to cross that threshold.
Second, sell investments in asset classes that exceed the planned allocation to bring them in line. Then use the proceeds from that sale to invest in those asset classes that have fallen below the allocation you want.
As part of this process, you should consider the tax implications of rebalancing. If you’re rebalancing a tax-advantaged retirement account, like an individual retirement account (IRA) or 401(k), you don’t need to worry about tax consequences because you don’t realize taxable gains within those accounts. But if you’re rebalancing a taxable brokerage account, you should explore options to minimize unnecessarily selling high-performing (and therefore highly taxed) investments.
Ways to Minimize Taxes When Rebalancing
To minimize the potential tax consequences of rebalancing in a brokerage account, you have a few options. Tax-loss harvesting or adding new contributions to your account can both help minimize the impact of your rebalancing strategy.
Avoid capital gains taxes by using new cash contributions to purchase assets that bring your allocation into balance. This lets you decrease the percentage of one asset by investing a disproportionate amount into another asset until balance is restored. You can also use stock dividend or bond interest payments from your existing investments for rebalancing.
You may also choose to take advantage of any capital losses through a process called tax-loss harvesting to decrease the amount you may owe on gains you sell to rebalance the portfolio. This involves selling assets at a loss in order to offset capital gains tax liabilities.
You may not be able to completely rid yourself of capital gains taxes using these techniques. But they should help somewhat reduce your capital gains tax liability from rebalancing.
Rebalance Your Portfolio Automatically with Robo-Advisors
Investing with a robo-advisor is a great way to ensure your portfolio gets the regular rebalancing attention it needs with no extra effort on your part. Robo-advisors automatically rebalance your portfolio to keep you on track to meet your goals.
It’s important to note that most robo-advisors charge management fees, typically 0.25% of the funds they manage for you each year. At most major brokerages you could perform the same services for yourself at no additional cost, but you may decide that paying a small fee is worth your while to make your investing experience entirely hands-off.
Most major robo-advisors, like Betterment and Wealthfront, include some level of tax-loss harvesting for clients, too.
Final Thoughts on Rebalancing
Rebalancing is an important part of managing an investment portfolio. Through rebalancing, you can keep the risk level of your portfolio consistent and perhaps even enhance your returns. When rebalancing, though, you have to be careful not to trigger excessive taxable income in taxable accounts.
