As you receive your year-end statements for mutual funds and brokerage accounts, you might be wondering, what’s on the horizon?
If that sounds like you, it may be time to start thinking about rebalancing your investment portfolio. But what is rebalancing? Why should you do it? What are the pros and cons of rebalancing? When is the best time to rebalance your portfolio?
I’ll get into all of that and more in this guide.
What is Rebalancing Your Portfolio?
In the simplest terms, rebalancing typically means that you periodically sell one type of investment and buy another to reset your portfolio. It can also entail adding funds and strategically investing in them.
Rebalancing serves as a way to safely reinvest your money under the mantra of buy low and sell high. It helps return your current asset allocations to a place closer to their original state of investment.
For example, if you start by investing 50% of your assets in stocks and 50% in bonds, then rebalancing would return your asset mix to that original ratio.
You are essentially selling off shares of some of your best-performing assets to buy some shares of the lower-performing ones. While this might sound counter-intuitive, diversifying your portfolio in this manner protects you against market fluctuations. It also helps you manage long-term risks.
Consider it a form of necessary maintenance for your mutual funds, much like how you occasionally take your car in for a tune-up. Any smart, forward-looking investor will want to make rebalancing a routine part of their investment strategy.
Understanding Asset Allocation
Rebalancing your portfolio maintains an ideal asset allocation, which refers to the specific mix (i.e., stocks or bonds) and distribution of assets in your investment portfolio. Over time, as the market (or your investment strategy) changes, this mix will inevitably change from your original investment.
Let’s take the above example of 50% of assets in stocks and 50% in bonds. For the sake of illustration, assume that this 50-50 ratio is the maximum amount of risk tolerance you are willing to allow.
If you have $10,000 in total to invest, you decide to invest $5,000 in an S&P 500 index fund and the other $5,000 in bonds. But over time, your stocks grow appreciably more than your bonds. Your stocks accumulate to a value of $10,000, whereas your bonds appreciate to only $6,000.
You might wonder why this growth would pose a problem. After all, your investment is now worth considerably more than what you put into it. While that growth bodes well for your financial future, you may have become too dependent on stocks, deviating from your initial 50-50 investment goals.
Therefore, it is time to restore your portfolio to its initial investment strategy. You do this by buying shares of the low-performing mutual funds and selling the high-performing ones until you return to that 50-50 ratio.
Betterment provides clients with personalized financial advice using a goals-based investing strategy. First, they identify your goals as an investor. Next, they consider your circumstances, such as expecting a child, buying a house, or switching jobs. Finally, they determine your risk level, the amount of money you should invest, and where to invest.
Reasons to Rebalance Your Portfolio
Now that we understand what rebalancing entails, let’s discuss why you should consider rebalancing your portfolio.
Diversify Your Risk
As an investor, you want to diversify your investments across different types of assets consistently. Rebalancing diversifies not only your assets but also your risk tolerance, ensuring an ideal risk-reward ratio.
As a reminder, stocks are generally high-risk and high-return, depending on the nature of the market. By contrast, bonds yield lower dividends but are also less prone to market fluctuations. You should assess your level of risk tolerance when you are investing.
Risk tolerance refers to the amount of risk you will tolerate when it comes to investments. If you are inclined to sell when your stocks lose a small percentage of their value, you might have low-risk tolerance and should maintain a portfolio that includes more stable investments such as bonds. The opposite approach (i.e., willingness to hold on to the stock or buy in this scenario) would indicate a high-risk tolerance level.
If you are nearing retirement age, you may not want to risk significant losses, so you should adopt a more conservative portfolio by prioritizing stable bonds over risky stocks. But a younger investor just getting started may be willing to take on more risks, favoring long-term gain over short-term losses.
Maintain a Long-Term Financial Outlook
While rebalancing can seem like a shock to your investments in the short term, it serves as an important way to keep your portfolio viable in the long run.
When markets temporarily dip in the future, you will be better positioned to recoup your losses when the markets eventually recover, as you will have offloaded bonds and purchased stocks when they are cheap. On the other hand, if the stock market performs well, you may need to rebalance by selling off some of your stocks if they take over the lion’s share of your investment portfolio.
Reallocating assets and diversifying risk can set you on a solid financial footing to build your future. A consistent rebalancing strategy can keep your less reliable impulses in check and prevent you from making emotional decisions at the slightest change in the market.
The Disadvantages of Rebalancing
Generally speaking, the pros of rebalancing outweigh the cons. But before you decide whether or how to rebalance, you need to be aware of the downsides.
Lack of Money
One way to rebalance is to inject new money into your assets. But if you do not have enough savings or a high enough income to add money to your accounts, you will have to sell off high-performing stocks, which is a risky endeavor.
Inexperienced investors could ruin their portfolios if they sell or buy the wrong assets. The stock market is volatile, and it can be hard to know which stocks to pick. Do considerable research on the stocks you want to rebalance. Seek the advice of trusted and experienced financial advisors.
For example, Empower’s fiduciary advisors provide personalized guidance based on your unique situation, all while using the latest financial tools. They offer three tiers of financial advice:
- Investment services for investors with $100,000-$200,000 in assets
- Wealth management for investors with $200,000-$1,000,000 in assets
- Guidance for private clients with more than $1,000,000 in assets
(Personal Capital is now Empower)
Loss of Money in Fees or Taxes
Experienced investors could face a significant capital gains tax by rebalancing a taxable account. They could also lose money through trading fees in tax-favored accounts like 401(k)s or IRAs, although the long-term gains of rebalancing typically offset such losses.
When is the Best Time to Rebalance Your Portfolio?
This is something of a trick question. Unfortunately, there is no magic bullet or golden date for rebalancing assets. Unlike airline tickets, you will not find that stocks are automatically cheaper or more expensive on certain days of the week.
A better question to ask yourself is: How frequently should I rebalance my portfolio? I suggest picking one of the following to help you decide on the best time to rebalance your portfolio:
- On pre-determined dates (i.e., once a year on your birthday)
- Toward the end of the year, as you consider tax strategies
- When you notice that your portfolio has strayed from your ideal asset allocation
- Some combination of the above
The history of trading shows that you need not rebalance that frequently. Large fluctuations in the market that can significantly alter your percentage of asset allocations rarely occur. Typical market fluctuations will only shift your allocations by a few percentage points. Rebalancing once a year works well for most investors.
In a bear market, rebalancing is a good idea to get your portfolio back on track. Still, you may also want to use this opportunity to reassess your level of risk tolerance. Has it changed since you first started investing? You should adjust your rebalancing strategy over time according to your changing circumstances and needs.
In general, rebalancing encourages you to buy when stocks are cheap and sell when they are pricey.
In case you don’t want to worry about timing, though, you can choose a robo-advisor like Wealthfront. Wealthfronts research team is comprised of Ph.D. experts who create data-driven financial planning advice tailored to your personal needs. With their interest in automated financial planning, Wealthfront is paving the way for investing in the 21st century. You do not need to have thousands of dollars to receive help. The minimum fees to open a Wealthfront account start at $1 for cash and $500 for investment accounts.
Tax Concerns with Rebalancing
Rebalancing works best when investing in a tax-favored account, such as an IRA or a 401(k). You should have few worries about the IRS scrutinizing your investment strategy’s tax implications in these accounts. You can defer capital gains taxes in these accounts until you withdraw your earnings, giving you many years to rebalance with no issue.
This investment strategy becomes more complicated when dealing with taxable accounts, in which case rebalancing may incur hefty capital gains taxes, depending on the level of investments and the scope of your salary. Should you decide to go forward, consider rebalancing in accounts with smaller gains. After all, with more significant gains comes more considerable taxes.
Moreover, consider rebalancing with stocks that you acquired more than a year ago. If you have had stock in your portfolio for more than a year, you will likely receive a better tax outcome. Tax auditors will consider stocks acquired less than a year ago to be ordinary income, facing the usual capital gains tax.
One option to consider to mitigate any issues with taxes is to hire a financial advisor through Paladin Registry. Founded in 2003 by a well-known finance guru, Paladin Registry offers a free service to pair vetted financial advisors with investors. Their vetting process considers advisors’ education, ethics, experience, and credentials. They will match you with top-flight advisors whose qualifications meet your specific investing needs.
Things to Do When Rebalancing Your Portfolio
Rebalancing may seem straightforward in theory, but you must consider many potential hurdles and unforeseen consequences in practice. By following the best practices laid out below, you will encounter far fewer challenges in your investment portfolio.
Check Your Accounts Regularly
Unless you have hired someone to manage your investments, you need to regularly pay close attention to your investment portfolio. Most mutual funds and brokerage accounts display daily account reports online. Alternatively, you can utilize software such as Quicken to track your earnings.
The purpose of keeping an eye on your asset allocations is not to determine the right day (or time of day) to rebalance, since that does not exist. Instead, this practice will foster consistency in your investment strategy, which will help your rebalancing long-term.
Assess the Stock’s Current Value and Future Prospects
As rebalancing entails selling successful stocks and buying ones with lower yields, investors may wonder which stocks to sell and which ones to buy. You will want to avoid selling off a winning investment with promising returns in the long run. Similarly, you will want to avoid buying a stock that will likely keep declining in value for the foreseeable future.
When deciding what to sell and buy, put aside the stock’s past performance and make your assessment based on its current value. If you would not be inclined to repurchase this stock today, then it is time to sell.
Keep in Mind Your Risk Tolerance
A risk-averse investor may rebalance accounts differently than an investor with a penchant for high-risk investments. You may also find that your risk tolerance level has shifted since you began investing, mainly due to a change in circumstances such as a salary raise, pay cut, loss of a job, or nearing retirement. Any significant life change may warrant a reassessment of your investment strategy.
Rebalance in Tax-Favored Accounts
As previously discussed, rebalancing in a taxable account may lead to significant capital gains taxes. Therefore, investors should rebalance in tax-favored accounts such as 401(k)s or IRAs.
Rebalance in Moderation
It is possible to have too much of a good thing. Investors should rebalance their accounts, but cautiously. Investors can develop a trigger finger, rebalancing one day, only to reverse their transaction as the market fluctuates later in the week.
Too many transactions can lead to excess taxes in taxable accounts and other fees. Your mutual fund may also restrict the number of transactions in a given period, making it difficult to undo hasty decisions.
You also do not need to rebalance all of your accounts to the same percentage of asset allocations if your overall portfolio meets your investment goals.
Rebalancing sounds scary at first. It is only natural to be hesitant when it comes to changing your financial portfolio, especially considering the many different calculations that go into rebalancing. If you need further guidance on rebalancing your portfolio, seek help from a trusted financial advisor.
Read more: 7 Ways to Improve Your Investment Returns
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