Rebalancing Your Investment Portfolio: Why, How, and When
Portfolio rebalancing is an important step to keep your investment goals on track. In this post, you’ll learn what rebalancing is, how it works, and why it’s important for maintaining your investment strategy. Let’s dive in…
What is rebalancing?
Let’s assume you and your financial advisor just finished updating your investment portfolio valued at $100,000, deciding on an asset allocation (your desired mix of stocks, bonds, and other investments) consisting of 60% in stocks ($60,000) and 40% in bonds ($40,000). The value of your investments will fluctuate throughout the year, impacting the proportion of each asset class in your portfolio and thus organically shifting away from the aforementioned 60/40 split. “Rebalancing” is simply the process used to adjust these weights back to their original allocation.
Risk tolerance and investing
Before getting into rebalancing specifics, it’s important to understand risk tolerance: one’s ability and willingness to tolerate large swings in investment value. After you and your financial advisor assess this—often via a questionnaire and conversations—as well as your risk capacity considering how much risk you can take on given your financial situation, he or she will then determine how to best allocate your money among different investments. Per the example provided above, this process initially determined the 60/40 split between stocks and bonds.
Since everyone’s appetite for volatility varies, the consequences of not knowing your specific tolerance are universal. Take on too much risk, and you might panic during downturns. Take on too little? You may not achieve your investment goals. Knowing your risk tolerance can ultimately minimize the likelihood of making impulsive decisions caused by market volatility.
How portfolio rebalancing works
Let's assume stocks dramatically outperformed bonds during a bull market, driving the value of your investment portfolio up to $110,000 and shifting your asset allocation to 70% stocks (valued at $77,000) and 30% bonds (valued at $33,000).
You feel uncomfortable, however, with 70% of your money in stocks—which are inherently volatile—and your financial advisor thus works to rebalance your portfolio back to its original allocation. This process typically involves selling stocks that have increased in value and are perhaps nearing their peak (selling high) while likewise purchasing bonds that have decreased in value but still hold potential (buying low).
Why you should rebalance your portfolio
In adjusting different asset weights to maintain your desired level of risk, reduce unnecessary exposure, and keep you aligned with your investment goals, portfolio rebalancing is truly a fundamental investment strategy: embodying the principle of buying low and selling high to ultimately optimize overall portfolio value.
Risks of not rebalancing
Haven't rebalanced your investment accounts? You’re not alone. Research indicates about 30% of people haven’t rebalanced their 401(k) or IRA, this number climbing to over 33% among people aged 25-54 and ringing in at 29% among those aged 55-64 and thus nearing retirement.
One of the biggest perils of not rebalancing is the potential to take on more risk than you initially intended or are comfortable with; wait too long to rebalance, and you could experience significant investment losses. Taking on excessive risk can also lead to impulsive investing decisions; emotions (particularly greed and fear) can cloud your judgement with respect to buying and selling investments, such mistakes easily derailing your long-term financial goals. During the 2008 financial crisis and early days of the COVID-19 pandemic, for example, many panicked investors sold stocks to avoid losses only to miss out on subsequent market recoveries.
When (and how often) to rebalance your portfolio
While rebalancing your portfolio too frequently can lead to unnecessary trading fees and tax implications that can diminish your holdings, doing so too infrequently can expose you to significant risks. So, when exactly is the right time to do this?
Unfortunately, hard-and-fast rules don’t apply in this case, and rebalancing isn’t necessary at all sometimes—especially if you believe some investments will continue to perform well despite the added risk. Nevertheless, it’s simply good practice to review your investments at least once a year and determine if rebalancing is required.
You can also set specific markers dictating you review your investments. While some investors choose regular time intervals such as quarterly or annually to assess their portfolios (“calendar rebalancing”), others set specific asset allocation thresholds (e.g., when an asset class such as bonds deviates from the initial allocation by a specified percentage)—a ladder approach known as “constant mix” or “trigger-based” rebalancing. You can also consider rebalancing whenever your goals or risk tolerance change, especially during major life events such as approaching retirement, expecting a child, buying a house, or experiencing a major health event.
In sum: why rebalancing your portfolio is important
Successfully executing a long-term investment strategy requires sustained discipline. With this in mind, periodically reviewing your asset allocations will help you achieve your investment objectives while maintaining your desired tolerance for risk.
Want to learn if your investments are ripe for rebalancing? Reach out to our CFP® professionals to enjoy a complimentary portfolio review and risk assessment and get the insight you need.
FAQs
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Yes, rebalancing involves buying and selling securities so costs are indeed involved.
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While the “5” indicates you should rebalance your portfolio whenever an asset class deviates from its original target allocation by 5% (e.g., a goal of holding 25% in international stocks means rebalancing when that percentage hits either 20% or 30%), the”25” refers to smaller portfolio asset classes (typically representing 10% or less). For example, if a metal (e.g., gold) constitutes 5% of your portfolio’s value, the “25” portion of the rule dictates you rebalance if the value of gold drops to 3.75% or rises to 6.25%.
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You can rebalance your assets held in tax-advantaged accounts (e.g., your 401(k) or IRA) without any need to worry about capital gains taxes, but when it comes to taxable accounts, you can implement a few rebalancing strategies without actually selling investments in order to avoid capital gains taxes. These include redirecting new contributions to underweighted classes, using interest or dividends from investments to buy underweighted classes, and leveraging tax-loss harvesting.
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.