You probably already know you need to monitor your investment portfolio and update it periodically. Even if you’ve chosen an asset allocation, market forces may quickly begin to tweak it.
For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want, and therefore a more aggressive portfolio than you originally intended. If the market corrects, your portfolio will go down more than you originally felt comfortable with, because you had more in stock than you originally intended, due to stock market appreciation.
Do you have a strategy for dealing with those changes? You’ll probably want to take a look at your individual investments, but you’ll also want to think about your asset allocation.
How rebalancing works
To bring your asset allocation back to the original percentages you set for each type of investment, you’ll need to do something that may feel counterintuitive: sell some of what’s working well and use that money to buy investments in other areas that now represent less of your portfolio.
Typically, you’d buy enough to bring your percentages back into alignment. This keeps what’s called a “constant weighting” of the relative types of investments.
Let’s look at a hypothetical illustration. If stocks have risen, a portfolio that originally included only 60% in stocks might now have 70% in equities. Rebalancing would involve selling some of the stock and using the proceeds to buy enough of other asset classes to bring the percentage of stock in the portfolio back to 60%. This example doesn’t represent actual returns; it merely demonstrates how rebalancing works. Maintaining those relative percentages not only reminds you to take profits when a given asset class is doing well, but it also keeps your portfolio in line with your original risk tolerance.
Methods for Rebalancing your Portfolio
Knowing that the market can be volatile and that rebalancing is a disciplined process that helps offset the risk of volatility, how do you know when to rebalance your portfolio? There are a couple of methods for rebalancing.
One common rule of thumb is to rebalance your portfolio whenever one type of investment gets more than a certain percentage out of line, say, 5 to 10%. This type of monitoring typically requires sophisticated software and an alert system to send you an automated alert whenever your portfolio is outside of acceptable balance range.
Otherwise it would be a daily manual exercise of updating the value of each investment and the relative value of the asset classes of the overall portfolio. This is a daily disciplined practice that most investors would not maintain on a sustained basis over years, which would be required. When we work with clients on an investment management basis, we use Target Bands as our method of rebalancing. We can do this because we have daily access to their account information and the software to monitor the accounts versus our target allocation.
You could also set a regular date for rebalancing. To stick to this strategy, you’ll need to be comfortable with the fact that investing is cyclical and all investments generally go up and down in value from time to time. When we work with clients on an hourly basis, we encourage them to come back to us on an annual basis for portfolio rebalancing. Because we do not have access to their accounts, we rely on investment statements that they provide us. In this situation, this is a good way to rebalance the portfolio back to the target allocation. The concern comes when too much time elapses between rebalancing periods and due to market fluctuation the portfolio can become an allocation that is not in line with their risk tolerance.
Our example has been about an appreciated stock market, because that is the market that we are experiencing. However, in a depressed market you would also want to rebalance. If stock prices go down, you might worry that you won’t be able to reach your financial goals because you no longer have the stocks needed to hedge against inflation, so you would want to rebalance back to your original asset allocation model. The same is true for bonds and other investments.
Balance the costs against the benefits of rebalancing
Don’t forget that too-frequent rebalancing can have adverse tax consequences for taxable accounts. Since you’ll be paying capital gains taxes if you sell a stock that has appreciated, you’ll want to check on whether you’ve held it for at least one year. If not, you may want to consider whether the benefits of selling immediately will outweigh the higher tax rate you’ll pay on short-term gains. This doesn’t affect accounts such as 401(k)s or IRAs, of course.
In taxable accounts, you can avoid or minimize taxes in another way. Instead of selling your portfolio winners, simply invest additional money in the asset classes that are underweighted in your portfolio. Doing so can return your portfolio to its original mix.
Sometimes rebalancing can be done in the tax deferred or tax free accounts, which will minimize the changes that need to be made in the taxable accounts, to minimize tax consequences.
You’ll also want to think about transaction costs; make sure any changes are cost-effective.
Also, look out for the impact that a sale in the taxable accounts can have in other areas of your financial plan. If your income goes up will it impact your FAFSA/college financial aid, Medicare means testing, Social Security benefit be taxed at a higher rate, put you in a higher income tax rate, etc.
No matter what your strategy, work with your financial professional to keep your portfolio on track.
Portions of this blog post are from an article prepared by Broadridge Investor Communications Solutions, Inc. Copyright 2017 But, I just had to add my own two cents!