As an investor, your portfolio’s performance is tied directly to the mix of assets you hold. Over time, the value of your investments fluctuates, potentially moving away from your original plan.
Rebalancing your portfolio is the process of adjusting your investments back to your original allocation. It’s not about perfection; rather, it’s about ensuring your portfolio stays aligned with your financial goals.
What is Portfolio Rebalancing?
Portfolio rebalancing is a strategy where you periodically buy or sell assets to maintain your desired level of risk and return. For instance, if you had originally planned to allocate 80% of your portfolio to stocks and 20% to bonds, market fluctuations could cause the stock portion to grow disproportionately. Rebalancing helps to bring your investments back in line with your initial targets.
Key Benefits of Rebalancing Your Portfolio
Minimizing Risk and Volatility
The primary goal of rebalancing is to control risk. Stocks can be volatile, but bonds are generally more stable. If your stock allocation becomes too high, your portfolio may become riskier than you’re comfortable with. Rebalancing can help restore the balance and reduce overall risk.
Enhancing Diversification
A well-diversified portfolio includes a mix of assets like stocks, bonds, and cash. Rebalancing ensures you are not overexposed to any one asset class, helping to reduce the impact of market swings on your overall portfolio.
When Should You Rebalance Your Portfolio?
There are two main approaches to rebalancing: time-based and trigger-based.
- Time-Based Rebalancing: This method involves rebalancing at fixed intervals, such as annually or semi-annually.
- Trigger-Based Rebalancing: Here, rebalancing occurs when the allocation of assets drifts by a set percentage from your target (e.g., 5%).
How Often Should You Rebalance?
Most financial experts recommend rebalancing once a year, but you may prefer to check your asset allocation every six months. Rebalancing too frequently could lead to unnecessary trading and costs, while waiting too long could expose you to increased risk.
Different Rebalancing Strategies
Percent Range Rebalancing
One popular method is to rebalance when an asset class deviates by a certain percentage (e.g., 5%) from its target. This strategy allows flexibility and avoids frequent rebalancing.
Calendar Rebalancing
In this approach, you rebalance at specific intervals—annually, semi-annually, or quarterly—regardless of market conditions.
Contribution-Based Rebalancing
If you’re adding new funds to your portfolio, you can use the new contributions to buy underrepresented assets, avoiding the need to sell overrepresented ones.
Steps to Rebalance Your Portfolio
Step 1: Analyze Your Current Asset Allocation
Start by reviewing your current asset allocation. You can use investment tracking tools or simple spreadsheets to keep an eye on how your portfolio is evolving.
Step 2: Compare Actual vs. Preferred Allocation
Look for any discrepancies between your current allocation and your target allocation. If your stocks have grown too much compared to bonds, it’s time to make adjustments.
Step 3: Sell Overallocated Assets
Sell a portion of your overallocated assets (e.g., stocks) to bring them back to their original level.
Step 4: Buy Underallocated Assets
Use the proceeds from the sale to purchase underallocated assets like bonds or cash equivalents.
Step 5: Add Funds to Rebalance
When adding new money to your portfolio, direct these funds into the asset class that is underweighted. This will help maintain your target allocation without needing to sell assets.
Rebalancing Without Selling Investments
You can rebalance without selling by contributing new funds to underrepresented asset classes. For example, if your portfolio is over-weighted in stocks, invest new money into bonds or cash until the balance is restored. Additionally, you can use withdrawals to adjust your allocation.
Pros and Cons of Portfolio Rebalancing
Pros
- Minimizes portfolio volatility and risk
- Improves diversification and consistency
- Helps avoid emotional decisions during market fluctuations
Cons
- Can trigger taxes on capital gains if done in a taxable account
- May reduce returns by selling winning investments
Rebalancing with a Robo-Advisor
Robo-advisors like Wealthfront and Schwab Intelligent Portfolios offer automated rebalancing. These platforms monitor your portfolio and automatically adjust your asset allocation as needed, based on your initial goals and risk tolerance.
Common Mistakes in Rebalancing
Avoid overtrading, which can lead to higher transaction costs and taxes. Stick to your long-term goals and don’t let short-term market fluctuations sway your decisions.
Tax Considerations in Portfolio Rebalancing
In taxable accounts, be mindful of capital gains taxes. You can reduce tax liabilities by offsetting gains with losses (tax loss harvesting) or by rebalancing through contributions rather than selling.
How Rebalancing Affects Long-Term Returns
Rebalancing can reduce returns in some cases by selling high-performing stocks. However, it reduces risk and smooths out volatility, providing more stability over the long term.
Should You Rebalance During Market Volatility?
Rebalancing during market volatility can be tricky. While it may be tempting to sell during a downturn, maintaining your strategy is usually the best approach for long-term success.
Conclusion
Rebalancing your portfolio is essential for maintaining your preferred asset allocation and reducing risk. By regularly reviewing your investments and making necessary adjustments, you can help ensure that your portfolio stays aligned with your financial goals. Whether you choose to do it manually or with the help of a robo-advisor, rebalancing keeps your investments on track.
FAQs
How much does it cost to rebalance a portfolio?
Most brokers no longer charge commissions on stocks or ETFs, but mutual funds or bonds may incur fees.
Can I rebalance without selling?
Yes, by adding new funds to underrepresented asset classes or using withdrawals.
Does rebalancing reduce returns?
While rebalancing can reduce returns by selling high-performing stocks, it also lowers risk.
What are the risks of not rebalancing?
Failing to rebalance can increase risk, as certain assets may grow disproportionately.
How often should I rebalance my portfolio?
Generally, rebalancing once a year or when asset allocations deviate by 5% is recommended.
