When you first start investing, you may have set up an initial portfolio that matches your investment style.
Once you've learned the ropes and start investing for a goal, such as retirement, your focus should be a bit more methodical.
Portfolio construction is not a one-time event, however. Asset prices change every day, and in some cases from second to second. Your asset allocation will eventually become unbalanced over time.
That’s where rebalancing comes in.
Here’s a look at how rebalancing works, and how you can do it all yourself.
What Is Rebalancing?
Before we begin, there are three terms you’ll need to understand:
- investment objectives
- risk tolerance
- asset allocation
Investment objectives are what you want to get out of your investments, such as growth or income.
Risk tolerance refers to how much volatility you can stomach with your investments.
Asset allocation refers to the distribution of your assets amongst investment categories. Your asset allocation should be based on the combination of your investment objectives and your risk tolerance.
Rebalancing preserves the risk-reward characteristics of your original asset allocation.
The purpose of your original asset allocation was to achieve your investment goals while taking on an acceptable level of risk.
If your portfolio gets out of balance, you might be taking on too much risk.
The way an asset allocation gets out of balance is if some asset classes perform better than other asset classes.
For example, let’s say stocks return 20 percent one year, while bonds only return 2 percent. By the end of the year, your allocation will have a higher percentage of stocks than you originally started with.
In other words, you would be out of balance.
Portfolio changes with gains & losses
Some investors might wonder why that would be a bad thing. After all, if stocks are doing well, shouldn’t they be owned? What is wrong with assets generating a high return?
The first reason is that the variability of returns for stocks is much higher than that for other assets, such as cash or bonds.
This means that a portfolio that has a heavier-than-usual weighting in stocks will also be carrying higher risk than you may have originally intended.
This is all well and good while stocks are going up. But, if stocks suddenly reverse and sell off, your portfolio would go down in value more than you might have planned on.
Meanwhile, the bond portion of your portfolio would be smaller than your original allocation.
This means a large part of your portfolio would be going down. Only a small portion would be going up.
Keeping an out-of-balance portfolio both increases your risk on the downside and lessens your exposure to the upside.
This isn’t to suggest that you shouldn’t have more stocks in your portfolio. But, allocating more money to stocks should be based on an investment decision, rather than the drift of the markets.
Think of rebalancing as a way to satisfy the investing maxim to “buy low and sell high.” When you rebalance, you’re forced to sell the portion of your portfolio that has gone up. At the same time, you’re forced to allocate more money to the portion of your portfolio that is “low.”
When Should You Rebalance?
You should rebalance whenever your portfolio gets significantly out of line with your original allocation.
What this means exactly can vary from investor to investor.
You shouldn’t obsess over your portfolio and rebalance it all the time. After all, your original allocation can be slightly out of line even one day after you set it up.
Many investment firms, including Fidelity, recommend that you rebalance once or twice per year. Others recommend quarterly rebalancing.
Fidelity also suggests that you should rebalance if any asset class is 10 percent or more away from your desired allocation.
Ultimately, you’ll have to make your own decision as to when you should rebalance. Just remember the principle behind rebalancing, which is to keep your risk tolerance in line with your original plan.
How to Rebalance
Here are the steps you should take when it comes time to rebalance your portfolio.
1. Look up your original asset allocation.
Your original asset allocation was a roadmap for your investments. It incorporated your investment objectives and your tolerance for risk.
The beauty of making an asset allocation is that you’ll have a written declaration of what your investments should be, according to investment principles that you decide.
This is invaluable because investing is often emotional.
When stocks are going down, it’s hard to believe that you should own them at all.
When stocks are going up, it’s hard to imagine owning anything else.
A formal, written asset allocation can help you keep your head straight when it’s hard to see through the fog.
2. Find your current asset allocation.
There are many online tools that can help you break down your current asset allocation. For example, investment research firm Morningstar offers an “Instant X-Ray” and “Portfolio Manager” that can each help you see and understand your current asset allocation.
Your brokerage firm may also divide your assets into categories for you.
Check your most recent brokerage statement. It probably groups all of your stocks into one category. If they’re not listed under “stocks,” the heading may be titled “equities.”
Your interest-bearing investments may be all grouped into a category dubbed “bonds” or something similar.
Your cash may be listed in another group. Investments such as certificates of deposit may also be listed here, under a category such as “cash and short-term investments”
But, you can also do all this work yourself.
Start with a simple asset allocation of stocks, bonds, and cash.
If you own additional assets, you can include additional categories.
For example, if you own annuities, you’ll need an insurance category. If you own gold, you’ll need a precious metals category, and so on.
Once you’ve assigned your assets to their proper categories, total the value in each section.
Divide this value by the total value of your portfolio to get the allocation in each category.
For example, let’s say the total value of your portfolio is $20,000, consisting of $10,000 in stocks, $6,000 in bonds and $4,000 in cash.
This means your stock allocation is 50 percent, your bond allocation is 30 percent and your cash allocation is 20 percent.
These are the numbers you should compare with your original asset allocation figures.
3. Find out where your asset allocation is out of balance.
Look again at your original asset allocation. Let’s say it looks like this:
- Stocks: 40 percent
- Bonds: 40 percent
- Cash: 20 percent
Sticking with the above example, let’s say your current asset allocation is:
- Stocks: 50 percent
- Bonds: 30 percent
- Cash: 20 percent
In this example, your stocks have had a good run, but your bonds have suffered.
In other words, your asset allocation is out of whack.
If you keep your allocation as it is now, the risk-reward characteristics of your portfolio will change.
In this example, you have the potential to generate more gains, but your portfolio is also taking on more risk. This is because stocks have a greater reward potential than bonds. However, they are also more volatile.
To regain your original risk and reward characteristics, you’ll have to perform your rebalance.
4. Rebalance your portfolio.
In the simplest terms, to rebalance your portfolio, you’ll need to sell some of the assets that have appreciated and buy more of the assets that are now under-allocated.
In this example, you’ll need to sell enough stocks so your allocation drops from 50 percent to 40 percent.
You’ll also need to buy enough bonds to raise your allocation from 30 percent to 40 percent. Your cash will remain the same.
Some investments are easier to rebalance than others.
Take your 401k plan, if you participate in one. Most 401k plans hold mutual funds as their primary investments.
To rebalance, most 401k trustees allow you to simply enter the percentage allocations you want for each fund and hit a button to rebalance.
If you own your own stock and bond portfolio, you’ll likely have to enter individual orders with your broker to trim and add positions as needed.
Cost and Tax Considerations
Rebalancing a portfolio can cost you money in the form of commissions. You might have to pay a commission or sales charge for every stock or bond that you buy or sell.
You may be able to avoid fees in a 401k plan, or if your portfolio consists of mutual funds that carry a free-exchange policy.
Unless your money is in a retirement account, such as a 401k plan or an IRA, you may face a tax bill every time you rebalance. If you sell your winners to reinvest that money in your losers, you’ll be triggering a capital gain. In a regular investment account, this may be a taxable transaction.
Rebalancing a portfolio is a way to keep you on track with your original investment plan.
It also removes emotion from the investment equation.
Set up rebalancing parameters based on time or allocation percentages so that you aren’t tinkering with your account unnecessarily.
Remember to take tax and cost considerations into account when it comes time to rebalance so that the act of rebalancing doesn’t negate its benefits.
Over time, a proper rebalancing strategy can help keep your portfolio right where it needs to be.