Portfolio rebalancing is the act of adjusting investment wights to make sure the portfolio remains consistent with an investor's financial goals and risk tolerance. Periodic rebalancing is recommended due to market value changes.
What Does It Mean to Rebalance Investments?
When an investor rebalances their portfolio, they adjust the weight of asset classes or individual holdings. As market values change over time, investors may find that their portfolio no longer has the right balance.
For example, if an investor begins with a 60% stocks / 40% bonds portfolio, but stocks rise 50% while bonds rise 10%, stocks may now represent more than 67% of the portfolio, while bonds make up less than 33%. At this point the portfolio might be too volatile for the investor, or yield too little income based on the account balance.
To return to a 60%/40% portfolio allocation the investor may conduct a rebalance, which will result in the selling of stocks and reinvestment of those funds in bonds.
Portfolio Rebalancing
Portfolio rebalancing involves adjusting one's portfolio to re-establish the original asset allocation balance.
Assets that perform well this year aren’t guaranteed to perform well next year and, if they don’t, then a portfolio could suffer subtantially. Rebalancing can help investors take advantage of short-term or medium-term outperformance of certain asset classes or holdings, returning asset allocation and portfolio risk to their original levels.
When To Rebalance
Rebalancing can be done in several different ways, depending on the assets in an investor’s portfolio and how much risk is associated with each. Additionally, all investors should consider any costs applicable to rebalancing such a commissions, bid-ask spreads, and possible fees charges by a financial advisor.
Some investors may prefer to rebalance their portfolio at fixed intervals, such as once per year. Other investors may rebalance only when their portfolio have breached an acceptable balance threshold. For instance an investor targeting a 60% equities/40% bonds portfolio may only rebalance if the equity proportion exceeds 70% or drops below 50%.
For many investors, one rebalance per year is likely sufficient, depending on market volatility. Completing a rebalance at the end of the year might be ideal so that an investor can see how potential tax consequences might impact them.
Automatic Rebalancing
Automatic rebalancing is the act of using financial tools or platforms to check on the balance of an investor’s portfolio and then to buy and sell assets to make sure it’s in line with the original asset allocation. It’s an easy way to make sure a portfolio is always in line with the original asset allocation because the investor doesn’t have to do any manual oversight of the balance of their portfolio. However, an investor could end up being charged unexpected fees depending on how often trades are made.
Note: Some administrators of SMA's (Separately Managed Accounts) may rebalance client portfolios at their discretion or based on a certain set of rules.
Importance of Rebalancing
The importance of portfolio rebalancing will vary depending on an individual investor’s tastes and financial goals. Some of the benefits and reasons to regularly rebalance a portfolio include:
To maintain a certain portfolio risk level.
To improve portfolio diversification.
To capitalize on short-term market movements of certain asset classes that could theoretically give up their gains.
Peace of mind and employing a disciplined approach instead of falling prey to difficult and emotionally-driven portfolio decisions.
Portfolio Rebalancing Strategies
There are a few different ways that investors can approach rebalancing of their portfolios. The most common rebalancing strategies are:
1. Calendar Rebalancing
Calendar rebalancing is the most common and basic. This approach involves analyzing investments within a portfolio at specific times throughout the year and making rebalancing decisions based on allocations at that specific point of time.
2. Percentage of Allocation
In this approach, every asset is assigned a specific tolerance level and when an asset class falls outside of that tolerance level then the portfolio will be rebalanced. For example, if a portfolio is meant to have 50% of its investments in bonds with a tolerance level of +/- 10%, then there will only be a rebalance if the value of bonds in the portfolio doesn’t fall between 40-60% of the total portfolio’s value.
3. Combined Approach to Rebalancing
A third approach is to combine the two most common strategies of the calendar rebalancing and the percentage of allocation. This strategy entails checking in on the portfolio’s balance on a regular schedule from monthly to yearly, but changes are only made if an asset class falls outside of its assigned tolerance levels.
Key Takeaway: Automatic rebalancing uses the percentage of allocation method and can cost quite a bit of money in transactional fees if the thresholds are set too small.
Rebalancing Without Paying Taxes
One big impact of rebalancing a portfolio can be the taxe liabilites that are triggered by selling portions of an asset class that has outperformed. Thankfully, there are a few things an investor can do to prevent a big tax hit. Here are some of the most common strategies:
- Use New Contributions: Instead of selling off an asset class and realizing a tax event, an investor can achieve a rebalanced portfolio by investing new contributions into the other asset classes that were underweight. This might be the cleanest way to avoid tax problems but it can be difficult if someone doesn’t have excess cash to invest.
- Rebalance in Tax-Advantaged Accounts: Rebalancing performed in tax-deferred accounts such as a 401k or IRA will help investors avoid large tax consequences. There is no immediate taxation on realized gains within these accounts. If an investor has both a tax-deferred account and regular brokerage account, they could even choose to conduct excess rebalancing of the tax-deferred account to offset an out-of balance brokerage account.
- Use Expected Capital Losses Offsets: Rebalancing of a taxable account will often result in the realization of taxable gains. However, if a certain investor already has net capital losses as the end of the tax year approaches, taxable gains from an end-of-year rebalancing may simply offset the losses already incurred elsewhere, resulting in no net taxable gains. The key is that the losses have to occur during the same tax period that the gains did. So, while this strategy works it could be a risky one for an investor to rely on without proper planning and professional guidance.
How to Rebalance a Portfolio
There are several ways for investors to rebalance their portfolios through advisors and financial tools, but when an investor wants to rebalance themselves then they should follow three main steps. The three steps to rebalancing a portfolio are:
Step 1: Review Asset Allocation
An investor should first look at the current portfolio asset allocation based on market values. These market values may have changed since the portfolio start date, or the prior rebalance date.
Step 2: Compare to Desired Allocation
An investor can then compare the current allocations with the desired allocations that were created when the investments began. The investor can assess whether certain variances are within their acceptable comfort range.
Step 3: Cash Flow Rebalancing
The investor ca rebalance the portfolio, if deemed necessary, by buying or selling assets that have varied from their original allocation. Cash flow rebalancing can include deposits, dividend reinvestments, or withdrawals depending on how the allocations have grown.
Bottom Line
Portfolio rebalancing can be a good way to make sure an investor’s portfolio doesn’t become stray too far from the initial plan. While there are many ways to manage rebalancing, all investors should keep in mind the tax consequences that are possible whenever selling any assets. However, the benefits of rebalancing may outweigh any of the negatives for many investors because it ensures the portfolio is on track to meet its financial goals.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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