Should I Rebalance My Portfolio?

Daniel Penzing
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What Is Asset Allocation Rebalancing?

Asset allocation is the process of how you divide your portfolio between various investment domains. One of the things you can do to improve your portfolio balance is to rebalance it.

Why Rebalance?

As a portfolio of assets grows, its composition gradually changes. For example, the more money you add, the more the proportion of stocks might grow. This is normal for

Balanced funds since typically they are actively managed. As you receive dividends, capital gains on stocks, or interest on bonds, these gains generally revert back into the stock market.

But this can create extra stock exposure that makes your portfolio unbalanced, and then your long-term results can actually be worse than the market average. It is therefore critical to check the relative weight of each investment within your portfolio.

Portfolio Logic

But if you’re not a fan of technical jargon, we can keep this simple.

How you allocate your money across different asset categories can impact your investing success, and you shouldn’t expect to get it right the first time. In fact, there’s a good chance you’ll make mistakes along the way. Having a concentrated portfolio in a single asset or

Industry can lead to poor performance.

Benefits of Rebalancing

Your investment weightings should change over time. A variety of factors can affect the performance of each investment. For example, you might have early-stage investments in some stocks (that you’ve held for a number of years) that are performing better than others. Maybe some of the stocks you bought have become market leaders, so they’ve gained more than other stocks you own. Alternatively, some stocks or bonds may have done poorly and fallen in relative value to your other holdings.

If you don’t rebalance, you’re essentially letting your winners run and your losers run (and run and run…). According to a study by Vanguard, you could let your winners run and lose 3% on average annually if you don’t rebalance.2

You could also end up with an unbalanced portfolio even if you don’t do this on purpose. It occurs when your holdings perform differently than anticipated. This could happen for a variety of reasons. For example, if your strategy was to hold a 60% equity, 35% bond, and 5% real estate, but you rebalance every year, you could end up with an 80%/20% mix simply because the stocks did better than expected.

Rebalancing Alternatives

If you are currently weighting your portfolio to a set asset allocation, you may have noticed that your portfolio value has recently changed. If you have been trading these assets to maintain a certain balance, the shifts could be making you doubt the current state of your portfolio.

The best alternative to rebalancing is a strategic asset allocation. A strategic asset allocation gives your portfolio targets that are defined by time, not by asset price. With a strategic asset allocation, investing means letting the fundamentals of the company and the economy drive your decision to buy or sell an investment.

Re-allocating to the strategic asset-allocation targets helps you avoid trying to time the markets. For example, if the Dow Jones Industrial Average (DJIA) falls, investors may want to sell their domestic stocks and shift to a more conservative allocation of the world stock market. Maybe that’s not a bad idea, but investors who unknowingly make a significant shift to an allocation based on the opinions of others may end up investing during that market dip. They are pushing to follow the crowd and will benefit from the inevitable increase in the market but won’t get the long term returns they could have received with a strategic asset allocation.

Tactical asset allocation makes it easy to chase performance and ignore fundamentals. For this reason, it is important to consider both the performance and the fundamentals and create a strategic asset allocation target.

Use New Money As Part of Your Rebalancing Strategy

Rebalancing your portfolio is going to be one of your best moves to stay on track with your goals- so it’s a good idea to do it at least once a year. If you’re an investor who isn’t accessing the markets at least once a year, the markets assume you don’t care anymore. Market activity is contrary to investors who are not accessing their accounts. So you can say the market wants you to rebalance your account.

Should you rebalance on goals not met? Do you have a pension, annuity or income program? Do you have enough liquidity in your accounts? Will you have enough to pay cash when you purchase the item instead of using debt?

These are all important questions you need to ask yourself when you explore rebalancing a portfolio. The answer is you should rebalance with new money. Try to avoid taking cash or other assets out of the portfolio. It is better to use new money from a client in your rebalancing process.

If you do use your money, make sure you have a good reason.

Rebalance Within Tax-Deferred Accounts

With any stock, bonds, or mutual fund you intend to hold onto indefinitely, it’s a good idea to occasionally rebalance. By rebalancing, you sell some of your gains and reallocate the proceeds to the underperforming areas of your portfolio. This is a great way to boost your returns in the long term.

In a 529 plan, the portfolio you select will automatically rebalance to reflect your target asset allocation. That’s because 529 plans are based on target-date funds, which automatically change the allocation percentages as you approach the target year. Your targets will vary, based on whether you have a retirement date or college date and whether you’re saving for your own education or a relative’s education.

Your target date fund is going to make the calls for you. In other accounts, you’ll need to monitor your portfolio performance, then bring your portfolio back into line.

You can rebalance through a rollover or a taxable sale.

Rollover is the easiest, if you’re working with the same plan you started with. Contact your plan administrator to request that your funds be directly transferred to your new account.

Offset Capital Gains and Losses

One of the tricks to managing a portfolio is offsetting the gains and losses.

If you’ve had a great year and have seen your portfolio climb, you’ll want to have enough losses to neutralize some of the gains. That way, when you file your taxes, you won’t have a large short term gain sitting in capital gains.

The gains will be offset by the losses.

On the flip side, if you’ve had a bad year and have incurred a number of losses, you’ll want to offset them with year end gains (or offset those gains as losses) in order to save on your taxes.

In a typical year, as your stocks go up, you sell a portion of those stocks to realize the gains and then buy back the same stocks.

So, when you sell the stocks at that gain, you can buy back the same stocks and offset the gain using a loss … or you can do what is called a Section 1042 rollover.

A Section 1042 rollover is done when you’ve had a significant gain (and you’re thinking you’ll have another significant gain for the next year).

Automatic Rebalancing

Should you rebalance your investments? To answer the question, you first need to understand how your portfolio losses and gains can affect the overall balance.

Rebalancing a portfolio is the process of buying and selling securities in order to maintain pre-established percentages of asset classes.

In general, rebalancing is the practice of selling a security that has appreciated in value and using the proceeds to buy a different security that has declined in value.

Some financial professionals recommend that you rebalance your portfolio each time there is a 10% or more change in one of the assets.

While rebalancing can help you keep your investments in line, you may want to consider that it can result in the following:

  • Increased transaction fees and taxes
  • Tax consequences if you sell appreciated assets
  • The assumption that one’s portfolio will return to its original asset allocations

Let’s take a look at how rebalancing can affect your portfolio.

Have a Plan and Stick to It

The stock market is an unpredictable beast, and you never know when the next economic downturn is going to strike. That’s why it’s important to stay the course and always keep your eye on your financial goals.

Avoid making big changes to your portfolio unless you know what you’re doing. The market is volatile enough without emotions getting in the way.

Here’s a quick checklist that you can use to decide if an adjustment needs to be made:

  • Are you in your target asset allocation?
  • Do you have an emergency fund for short-term financial needs?
  • Do you have a 3-6 month living expenses fund for financial emergencies?
  • Are your financial goals clearly defined?

If you can answer all of these questions with a yes, then your portfolio is probably in the right place. If you’re not sure or you’re struggling with any of these questions, then now is the time to make a move.