Rebalancing an investment portfolio is the process of making sure the proportion of asset types in your portfolio reflects your goals. It builds on two tenets of investing, diversification and consistency. It’s a necessary process because various securities rise and fall at different rates so that over time the asset allocation you chose when you created your portfolio will change. Consider working with a financial advisor on rebalancing. Here’s an overview of why, how and when to rebalance your portfolio.
Rebalancing Defined
Rebalancing is the act of switching up your investments to get back to the asset allocation you’re most comfortable with. Your asset allocation is the mix of securities you have in your portfolio based on your risk tolerance, goals and timeline. For example, if you’re very risk-averse, it’s best to have mostly bonds and cash in your portfolio.
There are two reasons to rebalance. One is to restore the proportion of asset types you designed your portfolio to have. Another is to modify that proportion because your investment goals have evolved and you want your portfolio to now reflect those newer choices.
Sometimes it’s not necessary for you to rebalance because it’s being done for you. If you have a target date fund, for example, the fund managers will do that for you. Some investment accounts, like 401(k)s may have an automatic rebalancing feature. Put in your percentages of asset allocation and it will keep that portion of your portfolio rebalanced for you.
How to Rebalance
Once you make your initial investments, they will either gain or lose. They will also generate income in the form of interest and dividends. As these changes occur over time, the initial asset allocation you chose will change. You may reinvest your dividends. You may add money to your top-performing investments, hoping to reap the benefit of dollar-cost averaging as they increase in value. Maybe you will follow the investing principle of buy low, sell high and add money to your lower-performing investments if they have a history of being good performers.
As you add money to your investments and reinvest dividends, your portfolio will no longer have the same asset allocation. If you had a 50/50 plan in place for stocks and bonds, those percentages will become gradually skewed. At the end of your first year of investing, you may have 60% stocks and 40% bonds, quite a bit off from your initial asset allocation plan.
When to Rebalance
In the example above, it’s clearly time for portfolio rebalancing. You will either need to sell some of your higher-performing stock or add money to the fixed-income portion of your portfolio to get your asset allocation back to the original 50/50 that you were comfortable with. This will shield you from more risk than you want since your portfolio is now heavy on equity securities. Rebalancing will get you back to your risk preference, initial investment goals and time horizon.
Many investor decide when to rebalance by choosing a rebalancing threshold, a percentage that represents how far the asset allocation of your investment portfolio has strayed from your plan. Will you rebalance if your asset allocations are 1% off? Or will you wait to rebalance when they’re 5% or 10% off? Those are questions you’ll have to answer based on your personal circumstances.
Another way to decide when to rebalance is to simply do it on a regular basis. You can decide to rebalance periodically, such as quarterly or every other month. Or you can rebalance a couple of times a year.
The Cost of Rebalancing
Before you buy or sell a single security, you’ll need to make sure you can afford to rebalance. Can you cover the fees you might have to pay upfront for purchasing a new asset or selling off one you currently have? It’s also a good idea to look at the expense ratio of the securities you’re interested in. That tells you what percentage of your assets are going toward management fees.
Besides the financial consequences of rebalancing, you’ll need to remember that the process could be somewhat time consuming. It’ll take longer than a few minutes to finish, so you’ll need to make room in your schedule to rebalance.
Don’t Forget About Taxes
As you rebalance, you’ll need to pay attention to how it might affect your tax bill. Selling profitable investments can trigger the capital gains tax, either short- or long-term. But luckily, you can minimize your tax bite by selling off assets that have experienced a loss and replacing them with others.
If you decide to use this strategy, known as tax loss harvesting, it’s important to tread carefully. If you replace a stock 30 days before or after selling one that’s almost identical to it, you’ll break the IRS’s wash-sale rule. If that happens, you won’t be able to use the loss to offset any of your gains until you sell off the similar shares later on.
Bottom Line
It’s important to rebalance your portfolio on a regular basis in order to adhere to your tolerance for risk, investment goals, and desired time horizon. Otherwise, your portfolio will gradually veer from your chosen path. If you want to change your asset allocation at some point, you can do that, but it should be planned and your own choice.
Tips on Investing
- If you’d like help with your portfolio, whether rebalancing or otherwise, consider working with a financial advisor. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s asset allocation calculator to help you balance and rebalance your portfolio.
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