Rebalancing your portfolio: What that means and how often to do it

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For many of us, investing is how we save for retirement, college education and other life events. After setting our financial goals and building a diversified portfolio, we can watch our investments grow over time. But as the years go by and situations change, we may need to adjust those investments. That’s where portfolio rebalancing comes in.

Essentially, portfolio rebalancing acts as a tune-up for your investments. It ensures your risk tolerance aligns with your long-term financial goals and gives you a chance to review the types of investments you hold.

How portfolio rebalancing works

When it comes to rebalancing, the first step is to take a look at your asset allocation.

Asset allocation is the mix of investments you own such as stocks, bonds, funds, real estate and cash. This asset allocation considers your risk tolerance and financial goals.

Someone who is more risk-tolerant might have a higher allocation to historically risky assets like stocks. On the other hand, a risk-averse investor might opt to have a higher weighting to less volatile asset classes like bonds or real estate.

When constructing a portfolio, the key is to understand how each asset class may impact your overall performance. By having a balanced portfolio, you are mitigating your risk of capital loss while increasing the likelihood of generating returns.

Once you determine your optimal asset allocation, there is a good chance those weightings will change as some investments perform better than others.

Consider a portfolio composed of 60 percent stocks and 40 percent bonds at the start of a bull market. Over time, that allocation will shift as stocks outperform bonds. You could end up with a portfolio of 80 percent stocks and 20 percent bonds if you don’t make any adjustments.

For an investor close to retirement, such an asset allocation could be too aggressive, especially if the stock market were to face a lengthy bear market.

By taking the time to review and adjust to your desired asset allocation, you can manage your portfolio’s risk and potentially buy low and sell high.

Types of portfolio rebalancing

There are generally two different ways to approach portfolio rebalancing:

• Calendar rebalancing: A calendar rebalancing strategy involves reviewing your portfolio at certain times during the year to determine whether rebalancing makes sense. This might be monthly, quarterly or annually.
• Trigger rebalancing: A trigger rebalancing strategy is when you rebalance your portfolio any time the allocations have drifted a certain amount from your desired allocation. For example, you may choose to rebalance any time the allocations have drifted five percent or more from the desired amount.

There are pros and cons to each approach, so you’ll want to think about which one makes the most sense for you. A calendar-based approach is fairly simple, but may cause you to rebalance more often than is necessary, while a trigger-based approach requires regular monitoring and may cause frequent rebalancing in volatile markets.

The importance of rebalancing a portfolio

Markets change, meaning your portfolio will need to change as well. Not doing so can lead to losses you might not have expected.

Returns will fluctuate, as will their weighting in your portfolio. For example, investments that were once considered safe could turn speculative in a couple of years and you will need to adjust accordingly to retain your desired allocation.

An investment you once considered low-risk and held, let’s say, 20 percent of your portfolio might turn risky in five years. Your weighting should then change to a lower amount to accommodate.

If you believe in the long-term value of certain investments, and have a lengthy time horizon, then holding on might not be a bad idea. If you, however, hold certain investments with the intent of maintaining a low risk profile, then you’ll likely need to rebalance your portfolio to reflect market movements.

Depending on what your investment goals are, not rebalancing your portfolio can see you incur significant losses that you might not be prepared for. It’s important to constantly keep up with your portfolio and the status of your investments.

How often should you rebalance?

There is not a hard-and-fast rule on when to rebalance your portfolio. But many investors make it a habit to revisit their investment allocations annually, quarterly, or even monthly. Others decide to make changes when an asset allocation exceeds a certain threshold such as 5 percent.

Research from Vanguard shows there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not markedly different.

Actually, by checking your investments too frequently, you might end up making emotional decisions in the moment instead of sticking to your long-term goals. Several studies of behavioral finance reveal investors might be tempted to alter asset allocations based on market volatility instead of their financial goals. Despite how often you check, the objective is to maintain a balanced risk profile over time.

Does rebalancing your portfolio cost money?

For the do-it-yourself investor, rebalancing a portfolio these days can be done at low or no-cost. Many brokerage firms offer commission-fee trades, while low-cost options abound.

Automated investing has also made portfolio rebalancing simple. Robo-advisors automatically rebalance asset allocations as part of their service based on investors’ profiles.

Many investors are still most comfortable working with a financial advisor. Of course, that personalized attention may come at a higher cost.

For retirement planning, it’s worth noting that target-date funds adjust portfolios over time as the fund gets closer to its target date. Though target-date funds usually come with a slightly higher cost than pure index funds.

Also, certain mutual funds might have early redemption fees, or even load fees. A load fee is a commission an investor pays when buying or selling mutual funds. These fees are determined by mutual fund companies and their intermediaries.

When deciding, it’s important to take note of these costs upfront. The more you can minimize unnecessary fees, the more you can invest toward your financial future.

Tax considerations when rebalancing

If you need to sell assets to rebalance your portfolio, take time to consider any tax implications.

Instead of selling, investors may also stop making new contributions to certain asset classes and redirect those funds to underweighted holdings as a way to rebalance over time. This strategy minimizes potential tax liabilities.

When rebalancing, it’s paramount to pay attention to the type of account your assets are in and the length of time you’ve owned them. These factors will determine how your capital gains or losses are taxed.

For example, rebalancing your assets in tax-advantaged accounts like a 401(k), IRA, or Roth IRA, will not incur any short- or long-term capital gains taxes. Alternatively, capital gains generated in standard investment accounts are taxable by the US government.

Before making any changes, you may want to consult with a tax professional.

Rebalancing for retirement

Outside of personal investment accounts, retirement accounts deserve special attention as your age will primarily determine how assets should be allocated.

The principles and strategies for rebalancing a portfolio are essentially the same. However, by taking a holistic view of all of your retirement accounts (401(k), IRA, Roth IRA), you might discover that your desired asset allocation is out of proportion.

When dealing with multiple accounts, consider consolidating all of them with an online portfolio tracker, or by keeping them at the same financial institution. Even if your accounts are actively managed, having them under one view should make it easier to track.

Target-date funds could also be advantageous for those investors who prefer a more hands-off approach. These managed funds change the risk profile based on your expected retirement age, selecting more conservative assets as you get older.

Bottom line

Rebalancing your portfolio is a great way to be in tune with your finances. It ensures you remain diversified and on track to reach your long-term financial goals.

Consider rebalancing your portfolio regularly or when your portfolio drifts too far from your desired allocations. This will help your portfolio align with your goals and risk tolerance.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.