Investors ideally have a plan for investing their portfolio that includes an asset allocation strategy. Over time financial markets will rise and fall, as will the value of the various holdings in your portfolio. It’s important for investors to periodically review their asset allocation against their plan and to rebalance their holdings back to this target allocation. Here is a seven-step rebalancing process to consider.
How to Rebalance Your Portfolio in 7 Steps
1. Set a Target Asset Allocation
You need a target to rebalance back to and this is your portfolio’s asset allocation. How much is appropriate for you to hold in stocks, bonds, cash and other types of assets? This will also include sub-asset classes within these broader categories.
Your target asset allocation should be an integral part of your overall financial planning. This includes your goals for your investments, your time horizon for your goals and the level of risk you are comfortable assuming.
This allocation should encompass your overall portfolio including taxable investment accounts as well as retirement accounts like IRAs and 401(k) accounts.
2. Set Rebalancing Parameters
You will want to set parameters for rebalancing. For example, if your target allocation to large cap U.S. stocks is 30% of your overall portfolio, you probably wouldn’t want to rebalance if these stocks comprised 29.7% of the portfolio at the time of your review. You may want to wait until there's a variance of about 5% from your target allocation before rebalancing. There is no magic number, so to speak, but the costs of rebalancing might outweigh the benefits when there's just a slight variation from your target allocation.
3. Review Your Asset Allocation at Regular Intervals
It’s rarely a good idea to review your investments or your asset allocation daily or even weekly. Set a regular time frame in which to review your portfolio’s asset allocation. Many experts recommend doing this no more than every three months, others suggest that semi-annually or even annually is sufficient.
4. Buy and Sell Assets
The most common way to rebalance your portfolio is to buy and sell investments within your portfolio accounts in amounts that will restore your portfolio’s asset allocation back to its target levels.
For example, if your desired allocation was 50% each to stocks and to bonds, but your portfolio has shifted to 60% stocks and 40% bonds. If the amount in your portfolio was $100,000, it would look like this:
- $60,000 stock fund
- $40,000 bond fund
In this case you would sell $10,000 of the money in the stock fund and then buy $10,000 of the bond fund to rebalance your portfolio back to your target 50/50 allocation.
While this is the most direct way to rebalance, it can trigger transaction fees and even generate taxable income in some cases.
5. Be Aware of Potential Taxes and Fees
Rebalancing can trigger transaction fees if the holdings you need to buy or sell trigger these fees. This could apply to trading stocks or ETFs, or to mutual funds that carry a transaction fee. If your mutual fund carries a surrender charge, this could trigger if you decide to sell a portion of the fund in the rebalancing process.
If buying and selling to rebalance occurs in a taxable account, this could mean both gains and losses on the investments sold. Capital gains on investments held for at least a year and a day will be long-term gains that are taxed at a preferential rate. When possible within a taxable account, be aware of which holdings have gains, including which are long-term and which are short-term. Also check to see if there are holdings with losses that can be sold and realized to either offset gains or be used in future years as needed.
If you have both taxable and tax-deferred retirement accounts, look to the tax-deferred accounts when possible to sell investments with gains.
6. Use New Money to Rebalance When Possible
If you are adding new funds to your portfolio, it makes sense to direct these new dollars to asset classes whose allocations have drifted lower than their target allocation. For example, in an up market environment for stocks your allocation to bonds may have drifted to a lower level than your target allocation due to the relative performance of stocks. If you are adding money to a taxable account or contributing to an IRA, you might direct all or that bulk of this money towards bond holdings. This would also apply to self-employed retirement plan like a SEP-IRA or a Solo 401(k).
If you are making salary deferral contributions to a workplace retirement plan like a 401(k) or a 403(b) you can redirect these contributions to areas where you might be under-allocated for a few pay periods until the area(s) that are under-allocated are more in line with your target.
7. Automate Where Possible
If possible, set up auto rebalancing if it’s available. This is a common feature in many 401(k) accounts. Auto rebalancing will allow you to set percentages for each holding in the account and then periodically will rebalance those holdings back to the percentage allocation that you specified for each holding.
You might set this up to happen every six months, annually or at some other interval. Note that this feature will only impact the particular account that it is available for, so you may need to take other steps to rebalance the rest of your accounts to get your overall portfolio in line with the desired asset allocation.
Take a Total Portfolio View
Rebalancing should be done with an eye towards your total portfolio’s asset allocation. If you have multiple accounts divided between taxable, tax-deferred retirement accounts it’s important that you take a total portfolio view when rebalancing. This means that the most important factor is the overall allocation of your portfolio, this generally outweighs the allocation of any one account. The types of assets held in various types of accounts, known as asset location, can also be an important factor and can make rebalancing easier over time.