Building a well-diversified investment portfolio is only half the battle when it comes to successful investing. Over time, market fluctuations can cause your asset allocation to drift away from your desired target. This is where rebalancing comes in—a disciplined process to adjust your holdings back to your original plan. In this article, we’ll explain what portfolio rebalancing means, why it’s important, different strategies to apply, and practical guidelines on when and how to do it.
What Is Portfolio Rebalancing?
Portfolio rebalancing is the process of realigning the weightings of your asset classes to match your established goals and risk tolerance. For example, if you originally decided on an allocation of 60% stocks and 40% bonds but a market rally causes stocks to make up 70% of your portfolio, rebalancing involves selling a portion of your stocks and buying bonds. This helps maintain your predetermined risk profile.
Rebalancing is not about predicting which asset will perform best; rather, it’s about keeping your investments aligned with your long-term plan. By consistently rebalancing, you enforce a “buy low, sell high” discipline, which can be key to long-term success.
Why Is Rebalancing Important?
Maintaining Your Desired Risk Level
Over time, different asset classes appreciate or depreciate at different rates. If stocks outperform bonds over several years, your portfolio could become more aggressive than you originally planned. Maintaining your desired allocation ensures you are not taking on more risk than you’re comfortable with.
Enhancing Long-Term Returns
Market fluctuations can introduce significant volatility. Rebalancing forces you to lock in gains from over-performing assets by selling some of them and reinvesting in under-performing ones that may rebound. Although this strategy doesn’t guarantee short-term profits, it can lead to more stable long-term performance and better risk-adjusted returns.
Promoting Disciplined Investing
Rebalancing removes emotion from the investment process. It requires you to adhere to a predetermined plan rather than reacting impulsively to market movements. This discipline is especially important during market extremes when investors might be tempted to abandon their plans.
When to Rebalance: Timing Strategies
Deciding when to rebalance your portfolio is just as important as knowing how to do it. There are several approaches:
Calendar-Based Rebalancing
Many investors choose to rebalance on a fixed schedule, such as annually, semi-annually, or quarterly. This approach is straightforward and helps ensure that your asset allocation remains consistent over time regardless of market conditions.
Pros:
- Easy to implement with set dates
- Removes the need to constantly monitor your portfolio
Cons: - Might lead to rebalancing when markets are not volatile, potentially incurring unnecessary transaction fees
Threshold-Based Rebalancing
Also known as percentage-based rebalancing, this method involves setting a specific deviation threshold from your target allocation. For example, you might decide to rebalance if any asset class moves more than 5% above or below your target weight.
Pros:
- Reactive to market conditions
- Helps capture market volatility and reduce drift
Cons: - Requires regular monitoring of your portfolio
- Can result in more frequent rebalancing, potentially increasing transaction costs
Hybrid Approach
Some investors combine both methods. For example, you might decide to check your portfolio quarterly and rebalance if any asset allocation has shifted by more than 5%. This approach balances the benefits of a scheduled review with the responsiveness of threshold-based rebalancing.
How to Rebalance Your Portfolio
Once you’ve decided on a rebalancing strategy, you need to execute the process effectively. Here are the key steps:
Step 1: Assess Your Current Allocation
Start by reviewing your portfolio and comparing your current asset allocation to your target allocation. Tools such as portfolio trackers and robo-advisors can simplify this process. Identify which asset classes have drifted significantly from your plan.
Step 2: Determine the Adjustments Needed
For each asset class, calculate how much needs to be bought or sold to return to your original or revised target percentages. For instance, if your target is 60% stocks and they now represent 70%, determine the dollar amount of stocks you need to sell to reduce that share back to 60%.
Step 3: Consider Tax Implications
Before selling any investments, especially in taxable accounts, factor in the tax impact of realizing capital gains. For some investors, using tax-advantaged accounts (like IRAs or 401(k)s) for rebalancing may reduce the tax burden. In taxable accounts, you might also consider strategies such as tax-loss harvesting to offset gains.
Step 4: Execute the Rebalancing
Use your brokerage’s platform to sell the over-weighted assets and purchase the underweighted ones. For investors who prefer a hands-off approach, many modern robo-advisors automatically rebalance your portfolio at pre-set intervals or when allocations deviate beyond your chosen thresholds.
Step 5: Document and Monitor
Keep a record of your transactions, noting the time and rationale behind each rebalance. After rebalancing, continue to monitor your portfolio over the next few months to ensure that your new allocation stays on track until the next scheduled review.
Practical Tips for Effective Rebalancing
Use Low-Cost Index Funds or ETFs
Rebalancing can sometimes involve multiple transactions across various asset classes. Using low-cost index funds or ETFs keeps transaction fees to a minimum, preserving more of your returns.
Automate Where Possible
If you prefer not to manually rebalance, consider platforms that offer automated rebalancing. Robo-advisors typically monitor your portfolio in real time and execute rebalancing when necessary.
Be Mindful of Transaction Costs
Especially if you are not using a commission-free broker, consider transaction costs when rebalancing. Over-trading may erode your overall returns. Balancing the need for discipline with cost efficiency is key.
Don’t Overreact to Short-Term Movements
Market volatility is normal. Resist the urge to rebalance too frequently in response to temporary market swings. Stick to your strategy and avoid making hasty decisions based on short-term trends.
Review Your Goals Regularly
Your risk tolerance and financial goals may change over time. Revisit and update your target asset allocation periodically to ensure it still aligns with your current situation. Major life events—such as retirement, marriage, or a significant change in income—may necessitate adjustments to your allocation and rebalancing strategy.
Case Study: Rebalancing in Action
Consider an investor, Maria, who set up her portfolio with a target allocation of 70% stocks and 30% bonds. Over the course of a few years, a bull market pushed the stock portion to 80% while the bond portion shrank to 20%. Recognizing the drift, Maria decided to rebalance.
Her strategy:
- Assessment: Maria reviewed her portfolio quarterly.
- Threshold: She adopted a 5% deviation trigger for rebalancing.
- Execution: In the quarter that stocks reached 80%, she sold a portion to reduce the exposure by 10%, and used the proceeds to purchase bonds.
- Outcome: By rebalancing, Maria maintained her targeted risk profile and was able to capitalize on the higher bond purchases during a period when bond values were relatively low, setting her up for stability when market volatility increased later.
Maria’s case illustrates the importance of discipline and the benefits of rebalancing—not only to maintain risk tolerance but also to potentially improve long-term returns.
When Not to Rebalance
While regular rebalancing is generally a sound strategy, there are situations where it might not be necessary or even advisable:
- During extreme market stress: In some cases, particularly during a market crash or during times of severe volatility, rebalancing might force you to lock in losses. It’s crucial to gauge whether the market move is temporary before making adjustments.
- When transaction costs outweigh benefits: If you have a small portfolio or if your brokerage charges high fees, the costs associated with frequent rebalancing may not justify the benefit gained.
- In highly tax-sensitive situations: For taxable accounts, if a rebalancing event would lead to significant tax liabilities, you might consider delaying until a tax-favorable time or using tax-loss harvesting strategies to mitigate the impact.
Alternatives to Rebalancing: New Contributions and Drifting Targets
For some investors, especially those contributing regularly to their portfolios, new contributions can naturally help rebalance asset allocation. For example, if your stocks have become overweight, directing new contributions to bonds can gradually bring your allocation back in line without selling existing assets.
Additionally, if your investment philosophy or goals change, you may intentionally let your asset allocation drift until you decide to adopt a new target. However, be cautious with this approach, as unmanaged drift can expose you to unintended risk.
Final Thoughts
Portfolio rebalancing is a crucial part of successful investing. It helps maintain your desired risk level, enforces disciplined buying and selling, and can enhance long-term performance by capturing gains from over-performing sectors while reinvesting in undervalued areas.
Key takeaways:
- Define your target asset allocation based on your risk tolerance, financial goals, and time horizon.
- Monitor your portfolio regularly using either a calendar-based, threshold-based, or hybrid approach.
- Execute rebalancing cautiously, considering tax implications, transaction costs, and market conditions.
- Keep your emotions in check. Rebalancing is a disciplined, strategic process that should be driven by your long-term plan rather than short-term market fluctuations.
By integrating a rebalancing strategy into your investing routine, you ensure that your portfolio remains aligned with your financial objectives. Over time, this disciplined approach can help reduce volatility and improve your overall investment performance.