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Effective investment management requires periodic rebalancing. Without it, you’ll execute something other than your intended plan.
But what is it, and how often should you do it?
This article will explain how portfolio rebalancing works and help you understand its benefits.
While reading, you may wonder how these tips could impact your rebalancing plan. Consider requesting a free Portfolio Checkup with one of our financial planning experts today.
What Is Portfolio Rebalancing?
Before we get into what rebalancing is, let’s set the stage.
When you create a portfolio, you (and your financial team) blend specific investments in a combination appropriate for your risk tolerance, risk capacity, time horizon, and goals. Here, you’re building a diversified portfolio that helps you reach your financial goals.
At a high level, you can think about the appropriate investment portfolio as a mix between stocks and bonds. For example, a retiree might hold 60% equities and 40% fixed income in their retirement accounts.
As markets move, each investment will react in different ways. Some markets may fall while others rise, or they may simply move at different rates. Over time, these differences will likely cause your portfolio to become out of balance, which can impact those measures we set at the beginning. For instance, the initial 60% stocks and 40% bonds portfolio might become 70% stocks and 30% bonds. This indicates that equities carry too much weight in that investment account.
Regular rebalancing re-aligns your portfolio and helps keep it functioning at its best for you. But to do that, you’ll need to buy and sell assets to maintain appropriate portfolio allocations and asset mixes.
Let’s bring some simple numbers into the mix. Say you have a $1 million portfolio. In this example, $600,000 would be the “right” amount to have in stocks. But after some market shifts, it has grown to $700,000. At the same time, your bond holdings should be $400,000 but are instead at $300,000. To correct this, you’d sell $100,000 worth of stock investments and buy $100,000 worth of bonds.
While this example focuses on stocks and bonds, there is a lot of diversity in the asset classes you’re investing in, like exchange-traded funds (ETFs), target date funds, bond funds, index funds, mutual funds, and more. Your specific allocations depend on your goals and investment strategy.
No matter your mix of investments, stock markets regularly shift and change and often experience volatility, so it may not be wise to check and rebalance your portfolio after every single market fluctuation. Trading too much can create excessive taxation and pull your investments even further out of whack.
Instead, it’s helpful to set guardrails that help you know when your portfolio is “off” target.
How Frequently Should You Rebalance?
There is no single correct rebalancing frequency. What is suitable for you depends on your circumstances, including your level of knowledge, tax situation, and the tools you have available.
However, regardless of how or when you choose to rebalance, you must set a regular time to evaluate your investments—monthly, quarterly, annually, etc.—to determine if a rebalance is necessary. You may or may not need to make any changes when you check, but unless you check, you won’t know. Regular monitoring helps you make more informed investment decisions.
At Covenant, we don’t use time-based rebalancing. Instead, we track variance from your intended target and rebalance it as your portfolio mix falls outside of your ideal target asset allocation by a specific percentage.
For example, if you have a 60/40 portfolio and we rebalance when your allocation drifts by 5%, we would rebalance any time the stock portion fell to less than 55% or increased to more than 65%. This strategy takes a more holistic approach to your ongoing asset allocation and larger investment goals.
We also think it’s imperative to be flexible enough to allow for changes outside your predetermined windows should the markets drastically shift. Sometimes the immediate effect is severe enough to warrant that extra attention.
A typical example is if the markets crash right as you retire. It may not make sense to rebalance after taking your income withdrawal if it would require you to sell stocks because you’d lock in the loss.
What Benefits Come From Rebalancing?
Rebalancing is necessary because it ensures your portfolio remains aligned with your short, medium, and long-term goals. Look at your accounts in combination with each other, as each account may have different goals.
Suppose you have a portfolio invested for long-term goals like retirement income, but the stock allocation has fallen significantly. In that case, you may actually be holding a portfolio that is better suited for medium or short-term goals like purchasing a vacation home in the next 5 years. You shouldn’t invest for retirement the same way as a major upcoming purchase.
Be specific, too. For example, consider whether you have raised enough cash for the quarter to cover monthly income distributions or future cash needs. If not, make sure you don’t sell the wrong investments and push your portfolio even further out of balance.
Rebalancing check-ins also give you a chance to evaluate how your allocations are working for you. If you need to make larger strategic decisions about your allocation, this is a perfect time.
For example, are there tax benefits like tax-loss harvesting that you can employ with your rebalance? What about net unrealized appreciation in retirement accounts as you start the transition into retirement?
Before You Rebalance, Set A Strategy
So you’ve decided that a regular rebalancing cadence is good. Great! But don’t start just yet.
There are some cons to consider.
Perhaps the most significant is that selling too frequently can increase potential capital gains exposure. This trade-off can be tricky at times. If your portfolio drifts too far out of balance, it may misalign with your goals. But if markets move fast and you rebalance too frequently, you’ll end up creating a good amount of tax drag with short-term capital gains.
This is one reason we often recommend setting a range that you allow your portfolio to drift within before it triggers any trades.
It would be best if you also considered the types of accounts that are more tax-friendly for rebalancing, like a 401k and IRA and not a taxable brokerage account. You may be able to adjust these accounts and leave your taxable accounts alone, thereby shielding the entire move from capital gains taxes.
If you employ this strategy, remember to look at each account and its role in the larger financial picture. If you touch one account, will you need to adjust another? Would doing so significantly alter your broader plan?
You also need to consider the transaction costs when buying and selling different assets.
Get Rebalancing Help
Remember, your goal when rebalancing is to maintain diversification and risk exposure long-term.
The bottom line is there’s a lot to think about when it comes to rebalancing your investment portfolio. Do you understand how rebalancing can help your overall portfolio management but are not sure you want to tackle it on your own?
Reach out to your financial advisor for help.
Rebalancing is an important component of your personal finance health. Each of our clients has a rebalancing strategy that we monitor and implement. We can help you too. Start by requesting your free Portfolio Checkup.
Broderick Mullins, MBA
Broderick is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors serving clients across the United States. He specializes in helping individuals aged 50 plus create, implement, and protect a personalized financial plan for retirement.
Disclosures
Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account.
Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place.