Investing isn’t just about choosing the right assets, but also about managing those assets over time. As markets rise and fall, your investment portfolio can drift away from its original target allocation. This is where rebalancing comes in. Rebalancing helps ensure that your portfolio remains aligned with your financial goals and risk tolerance.
In this article, we’ll explain what rebalancing is, why it’s important, and how to do it effectively.
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What Does Rebalancing Mean?
Rebalancing is the process of realigning the weightings of your portfolio assets back to your original target allocation. For example, if you wanted your portfolio to consist of 70% stocks and 30% bonds, but due to strong stock performance it shifts to 80% stocks and 20% bonds, you would need to sell some stocks and buy more bonds to bring the portfolio back to its original allocation.
Why Rebalancing is Important
Over time, different assets in your portfolio will perform at different rates. Stocks might grow faster than bonds, or vice versa, which can shift your portfolio’s risk profile. By rebalancing, you ensure that your risk remains in line with your original financial plan, preventing your portfolio from becoming overly risky or too conservative.
Rebalancing also forces you to adopt a disciplined investment approach. You’ll sell high-performing assets and buy underperforming ones, effectively following the classic investment advice to “buy low and sell high.”
When Should You Rebalance?
There are two main approaches to rebalancing:
- Time-based rebalancing: This involves rebalancing your portfolio at regular intervals, such as quarterly, semi-annually, or annually. Many investors choose to review their portfolios once a year to assess whether rebalancing is necessary.
- Threshold-based rebalancing: This approach involves rebalancing whenever your asset allocation drifts by a certain percentage (usually 5% or 10%) from your target. For instance, if your target allocation is 70% stocks and 30% bonds, but stocks grow to 80%, you would rebalance to bring the allocation back to 70/30.
Understanding Asset Allocation
Asset allocation is the mix of stocks, bonds, and other investments in your portfolio. The goal is to balance risk and reward by adjusting the percentage of each asset class according to your risk tolerance, investment goals, and time horizon.
How Asset Allocation Drifts Over Time
Due to the nature of the markets, the performance of different asset classes changes over time. For instance, during a bull market, stocks may significantly outperform bonds, causing your portfolio to become stock-heavy and riskier than you intended. This is what’s known as portfolio drift.
Rebalancing Methods
When rebalancing, there are a few ways to bring your portfolio back in line with your target allocation:
- Sell overperforming assets and buy underperforming ones: This is the most direct way to rebalance. By selling assets that have exceeded your target allocation, you can use the proceeds to buy assets that have fallen below their target.
- Use new contributions: Instead of selling assets, you can use any new contributions to your portfolio to buy more of the underweighted assets. This is a cost-effective way to rebalance, as it avoids transaction fees and potential tax implications.
Pros and Cons of Rebalancing
Pros:
- Risk control: Rebalancing keeps your portfolio in line with your risk tolerance.
- Discipline: It encourages a disciplined investment strategy, ensuring you aren’t swayed by emotions.
Cons:
- Transaction costs: Depending on your brokerage, selling and buying assets can incur fees.
- Taxes: Selling investments may trigger capital gains taxes, especially in taxable accounts.
Tax-Efficient Rebalancing Strategies
To minimize the tax impact of rebalancing, consider doing so within tax-advantaged accounts like IRAs or 401(k)s. Investments in these accounts grow tax-deferred, so you won’t owe taxes on gains until you withdraw the money.
If you’re rebalancing in a taxable account, you can minimize capital gains taxes by selling only a portion of your overperforming assets or using losses from other investments to offset gains.
Rebalancing with Dollar-Cost Averaging
Dollar-cost averaging involves investing a fixed amount of money at regular intervals, regardless of market conditions. You can use this strategy to rebalance your portfolio gradually. Instead of making large adjustments all at once, you can direct your regular investments toward the asset classes that are underweighted.
Rebalancing for Different Investment Goals
The frequency and method of rebalancing may depend on your investment goals and time horizon. For short-term goals, you might rebalance more frequently to ensure your portfolio is protected from market volatility. For long-term goals, you may only need to rebalance once a year or when there’s significant drift in your allocation.
Using Automated Rebalancing Tools
Many robo-advisors and investment platforms offer automatic rebalancing as part of their services. This can take the hassle out of portfolio management by automatically adjusting your assets based on your target allocation.
Emotional Discipline in Rebalancing
Investors are often tempted to let their winners run, especially in a bull market. However, failing to rebalance could leave you overexposed to risk. Rebalancing requires emotional discipline—selling assets that have performed well and buying those that haven’t. It’s important to stick to your plan, even when it feels counterintuitive.
Rebalancing in a Bull Market
During a bull market, stocks might grow faster than other asset classes, causing your portfolio to become more aggressive than intended. Even though it’s tempting to ride the wave, you should rebalance to ensure that your portfolio remains aligned with your risk tolerance.
Rebalancing in a Bear Market
In a bear market, your more conservative
assets, such as bonds, might outperform stocks. Rebalancing during these periods ensures you don’t miss out on potential gains when the market recovers. It also prevents you from panic selling during downturns.
Common Mistakes to Avoid When Rebalancing
- Waiting too long to rebalance: Delaying rebalancing can leave you with a portfolio that’s much riskier or more conservative than you intended.
- Focusing only on gains: Remember that rebalancing isn’t just about selling winners; it’s about maintaining your desired level of risk.
Rebalancing as You Near Retirement
As you approach retirement, you’ll likely want to shift to a more conservative asset allocation. Rebalancing becomes even more important during this time to protect your nest egg from market volatility.
Conclusion
Rebalancing is a crucial part of maintaining a healthy investment portfolio. By regularly reviewing and adjusting your portfolio, you ensure that it remains aligned with your financial goals and risk tolerance. Stick to a disciplined rebalancing strategy, whether you do it manually or use automated tools, and you’ll be well on your way to long-term financial success.
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FAQs
- How often should I rebalance my portfolio?
- You should typically rebalance at least once a year or whenever your asset allocation shifts by 5% to 10%.
- What’s the easiest way to rebalance a portfolio?
- Many investors use automated rebalancing tools offered by robo-advisors or investment platforms to simplify the process.
- Can I rebalance without selling investments?
- Yes, you can use new contributions or dividend reinvestments to bring your portfolio back to its target allocation without selling assets.
- Should I rebalance my portfolio during a market crash?
- Yes, rebalancing during a market crash can help you maintain your risk tolerance and prepare for potential market recovery.
- How does rebalancing affect taxes?
- Rebalancing in a taxable account may trigger capital gains taxes, but using tax-advantaged accounts or harvesting losses can help minimize the tax impact.