Tips to Rebalance Your Portfolio

When the market is volatile, it's a good time to take a look at your asset allocation
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It’s important to periodically review your portfolio and rebalance your asset allocation back to your target allocation. The recent volatility in the stock market is a good reason to review and rebalance things if needed.

What Is Portfolio Rebalancing?

Portfolio rebalancing is the process of adjusting the holdings in your investment portfolio to bring them back in line with your target asset allocation. This can be done in a number of ways including buying and selling holdings within portfolio to bring things back in line, or in some cases using new money that is being invested to bring the allocation percentage of certain asset classes back to their target level.

Rebalancing can be done across your entire portfolio, including taxable accounts and retirement accounts, or within specific accounts based on the investor’s needs and objectives.

Why Is Rebalancing Important?

Rebalancing is important to ensure that your portfolio stays aligned with your target asset allocation, which is presumably based on your financial plan, your goals, objectives and risk tolerance. Over time certain asset classes will outperform others. This can cause your asset allocation to vary by more than an acceptable amount from your desired allocation.

When your allocation varies significantly from the target you’ve set, this can lead to your portfolio taking on too much risk or too little risk.

For example, over the period from early March of 2009 to the market highs of February of this year, more often than not stocks outperformed bonds and cash. If left unchecked, your portfolio would remain over-allocated to stocks, causing you to take on more investment risk than your plan and more than you might be comfortable with. A portfolio in this position prior the market downturn brought on by the coronavirus would likely have experienced a greater hit than if it had been rebalanced back to its target allocation prior to the market decline.

On the other hand, the market decline over the past few weeks has likely impacted the equity allocation most investor’s portfolios. This may be a good time to go in and review your portfolio’s allocation and rebalance back to your target allocations.

How Often Should You Rebalance?

Opinions vary, but many professionals caution against rebalancing too often. Intervals such as quarterly, semi-annually or even annually are often suggested. These would be time frames in which to review your portfolio to determine if rebalancing is needed.

It makes sense to set parameters to determine if your portfolio should be rebalanced. For example if the allocation for an asset class is within a range of plus or minus 5% of the target allocation for that asset class then no rebalancing adjustment would be done for that asset class.

Some workplace retirement plans such as 401(k)s and others may allow participants to set up automatic rebalancing at a set interval. The participant would log into their account and set their desired allocation and the desired interval for the account to be rebalanced to that target allocation. They would need to go into each holding they utilize within the plan and input the target percentage for that holding.

Rebalancing Tips and Considerations

The most common way to rebalance your portfolio is to buy and sell existing holdings within your various accounts.

When looking to rebalance, here are some tips and considerations to keep in mind:

Taxes should be considered where possible. Sometimes rebalancing will entail selling portions of some holdings at a gain. This could especially be the case if a portion of the portfolio has performed well over a relatively short period of time. If possible, sell appreciated assets housed within an IRA, 401(k) or other type of retirement account. You’ll want to be careful not to sell off too much of any asset class within the retirement account as this can ultimately diminish the benefits of tax-deferred or tax-free (in the case of a Roth account) growth over time.

Use tax-loss harvesting where possible to offset any gains in taxable accounts. Especially in light of the recent market declines, your portfolio may have some positions that have turned into losses. If it fits into your rebalancing strategy, use these losses to the extent possible to offset any gains that you might realize in the process of rebalancing. This process can be refined a bit more to maximize losses if you have been able to group the cost basis of your holdings by tax lot based on multiple purchases you may have made over time, versus using the more standard average cost method.

Use new money to rebalance. This means that you should direct new money invested to areas of your portfolio that are under-allocated in comparison to your target asset allocation. This can work well in an account like a 401(k) where you contribute new money each pay period. If your allocation to bonds was a bit low, you might consider directing all new contributions to a bond investment choice within the fund for a period of time. You can also use this method with a taxable account and with contributions to an IRA account. The use of new money may not be enough to cover all of the rebalancing needed, but it can help in the process.

Review Your Asset Allocation Periodically

Rebalancing is an important tool, but it's also important to ensure that your target asset allocation is still appropriate for your situation. This should be part of the larger process of reviewing your overall financial plan periodically to see if it still applies as is, or if some tweaks are needed.

If this review of your financial plan dictates a change in your asset allocation and your investment strategy, this new allocation should become your target. Your initial portfolio rebalancing after this plan review should be to the new target allocation, and that target should be used in subsequent rounds of rebalancing.

Asset allocation has been called one of the key factors in an investor’s return from their investments. Keeping your portfolio in line with your target asset allocation via periodic rebalancing can be an important tool in your success as an investor.