Managing an investment portfolio isn’t a “set it and forget it” process.
To maintain the right balance of risk and return, your portfolio needs ongoing attention, including regular rebalancing.
This essential practice helps ensure that your investments stay aligned with your financial goals and risk tolerance, even as market fluctuations affect your asset allocation.
In this guide, we’ll explore why portfolio rebalancing is important, how it works, and the steps you can take to rebalance your portfolio effectively.
What Is Portfolio Rebalancing?
Portfolio rebalancing involves adjusting the allocation of assets in your investment portfolio to maintain your target risk and return profile.
Over time, some investments may perform better than others, causing your portfolio to drift away from its original allocation.
Rebalancing helps you bring your portfolio back in line with your goals by selling some of the overperforming assets and buying more of the underperforming ones.
Example of Portfolio Drift:
Imagine you set up a portfolio with 60% in stocks and 40% in bonds. After a strong year in the stock market, the value of your stock holdings grows faster than your bonds.
Now, your portfolio may have shifted to 70% stocks and 30% bonds, increasing your risk exposure.
To restore balance, you would sell some of your stocks and use the proceeds to buy more bonds, bringing the portfolio back to the original 60/40 split.
Why Is Portfolio Rebalancing Important?
Rebalancing is critical for several reasons, each of which plays a role in keeping your portfolio aligned with your overall financial strategy.
1. Maintain Your Desired Risk Level
The primary reason for rebalancing is to maintain your desired level of risk. When one asset class (like stocks) grows disproportionately compared to others (like bonds), your portfolio’s risk exposure increases.
This can make you more vulnerable to market downturns, especially if your portfolio becomes too heavily weighted in volatile assets like stocks.
By rebalancing, you reduce the risk of overexposure to any one asset class, keeping your portfolio in line with your risk tolerance.
2. Ensure Consistency with Financial Goals
Your financial goals are likely tied to specific time horizons—whether you’re saving for retirement, buying a home, or funding your child’s education.
Each of these goals may have different risk tolerances, and rebalancing ensures that your portfolio stays aligned with those goals.
For example, if you’re nearing retirement, you may want to gradually reduce your exposure to stocks and increase your holdings in safer, income-generating assets like bonds.
Regular rebalancing helps you shift your portfolio to match these changing needs.
3. Take Advantage of Market Opportunities
Rebalancing can also serve as a disciplined way to “buy low and sell high,” a cornerstone of successful investing.
When you rebalance, you sell a portion of the assets that have performed well and reinvest in assets that may have underperformed but have long-term growth potential.
This helps you capitalize on market cycles and avoid the trap of chasing past performance.
4. Control Emotional Investing
Investors are often tempted to let emotions guide their investment decisions, especially during periods of market volatility.
Regular rebalancing provides a systematic, unemotional approach to managing your investments.
By following a predefined strategy, you avoid making impulsive decisions based on short-term market fluctuations, which can derail your long-term financial plan.
How Often Should You Rebalance Your Portfolio?
There’s no one-size-fits-all answer for how often you should rebalance your portfolio. However, many financial advisors recommend doing so at least once a year or whenever your asset allocation drifts by a certain percentage, typically between 5% and 10%.
Here are a few common approaches to determining when to rebalance:
1. Time-Based Rebalancing
This method involves rebalancing at fixed intervals, such as annually, semi-annually, or quarterly. It’s a straightforward approach that ensures you check in on your portfolio regularly, making adjustments as needed.
For most investors, annual rebalancing is sufficient to maintain alignment with long-term goals while minimizing transaction fees.
2. Threshold-Based Rebalancing
With threshold-based rebalancing, you monitor your portfolio’s asset allocation and rebalance when it deviates from your target by a set percentage—typically 5% to 10%.
For example, if your target allocation is 60% stocks and 40% bonds, you may decide to rebalance if stocks reach 65% or fall to 55%.
This method allows for more flexibility and responds to actual market movements, though it requires more frequent monitoring.
3. Hybrid Approach
Some investors combine time-based and threshold-based rebalancing, reviewing their portfolios at regular intervals but only making adjustments if the asset allocation has drifted beyond a certain threshold.
This approach offers the best of both worlds, ensuring regular oversight while minimizing unnecessary trades.
Steps to Rebalance Your Portfolio Effectively
Rebalancing your portfolio doesn’t have to be complicated. Here’s a step-by-step guide to help you do it effectively:
1. Review Your Target Asset Allocation
Before rebalancing, revisit your target asset allocation based on your financial goals, risk tolerance, and time horizon. This allocation serves as your baseline and will help you determine how far your portfolio has drifted.
2. Assess Your Current Portfolio Allocation
Look at the current value of each asset class in your portfolio. Compare these allocations to your target percentages.
If you see that one asset class has grown beyond its target, it’s time to consider rebalancing.
3. Buy and Sell to Rebalance
To rebalance, sell a portion of the overperforming assets (those that have grown beyond your target allocation) and use the proceeds to buy underperforming assets.
This brings your portfolio back in line with your desired allocation.
4. Minimize Transaction Costs
Rebalancing can sometimes incur transaction costs, especially if you’re frequently buying and selling investments. To minimize costs:
- Consider rebalancing less frequently if you’re a long-term investor.
- Use low-cost index funds or exchange-traded funds (ETFs) to reduce trading fees.
- Rebalance within tax-advantaged accounts like IRAs or 401(k)s to avoid triggering capital gains taxes.
5. Automate Rebalancing Where Possible
Some financial platforms and robo-advisors offer automatic rebalancing services, adjusting your portfolio at regular intervals or when your asset allocation drifts by a certain percentage.
Automating this process ensures that your portfolio stays aligned with your goals without requiring constant monitoring.
Tax Considerations When Rebalancing
When rebalancing a taxable account, keep in mind that selling investments can trigger capital gains taxes.
These taxes apply when you sell an asset for more than you paid for it, and the amount you owe depends on how long you held the investment.
- Short-term capital gains (on assets held for less than a year) are taxed at your ordinary income tax rate.
- Long-term capital gains (on assets held for more than a year) are taxed at lower rates, typically 0%, 15%, or 20%, depending on your income.
To minimize tax liabilities, consider rebalancing within tax-advantaged accounts, such as IRAs or 401(k)s, where gains aren’t taxed until you withdraw the funds.
Disclaimer: We are not licensed accountants, and the information provided in this section is for educational purposes only. Tax rules and regulations can change, and individual circumstances vary. We recommend consulting with a licensed accountant or tax professional for personalized advice before making any decisions related to rebalancing your portfolio or managing capital gains taxes.
Stay on Track with Regular Portfolio Rebalancing
Rebalancing your portfolio is a critical part of maintaining a sound investment strategy.
By periodically adjusting your asset allocation, you ensure that your portfolio stays aligned with your risk tolerance and long-term financial goals.
Whether you choose to rebalance on a fixed schedule or based on portfolio drift, the key is to maintain a disciplined approach that helps you navigate market fluctuations while staying focused on your objectives.
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