How to rebalance a portfolio

In an ideal situation, a financial advisor or an individual creates an investment portfolio with an eye toward accomplishing a goal or even a series of goals. That could mean anything from purchasing a home, to putting children through college, to providing for a secure retirement, or any other investment objective.

However, you can’t just set up a portfolio and expect it to perform consistently throughout the years. A balanced portfolio requires ongoing review and rebalancing to retain its intended allocation.

Over time, the portfolio you’ve created to help grow your personal capital can devolve if left alone, hindering your ability to reach your financial goal. That’s because each asset class and market sector you own will perform independently – and differently – from each other.

Some investments may rise in value more than others, and some may fall in value more than others. And as time goes on, your portfolio will cease to resemble the asset allocation that was originally created. This is called portfolio drift.

That’s where rebalancing your portfolio comes in.

Simply put, portfolio rebalancing involves buying and selling securities so that the weighting of each asset class stays consistent with the original allocation.

For example, let’s say that you initially constructed your portfolio with a target asset allocation of 60% stocks and 40% bonds. However, over time, the bonds outperformed the stocks and now your portfolio consists of 45% bonds and 55% stocks.

In this scenario, rebalancing would require selling some higher-performing bonds and using the proceeds to buy stocks. This helps you reset your portfolio allocation to the original 60:40 distribution.

Regular rebalancing helps manage portfolio risk and gives you the opportunity to revise your portfolio allocation should your risk tolerance or financial goals change.

To understand why it’s essential to have a rebalancing strategy, we first need to discuss the importance of asset allocation.

While stocks generally outperform bonds in the long term, they also come with greater risks due to the potential for market volatility. To hedge against the risk of fluctuating stock values, investors use bonds, which can be a lower-risk, lower-return investment option.

Using the example above, the 55:45 distribution prior to the rebalanced portfolio may represent a less risky asset allocation than the original – but it also may grow much slower. In contrast, a target allocation of 70% stocks and 30% bonds would likely pose more risks with the potential for increased capital gains.

Your desired asset allocation will primarily depend on your current financial goal and situation.

For instance, a riskier investment strategy might be right for a young adult trying to grow their wealth because they have time to make up for potential losses. On the other hand, the same individual investor might consider a lower-risk strategy to help protect their savings as they approach retirement age.

Of course, portfolio drift doesn’t take decades to occur, so regularly reviewing and rebalancing your portfolio is a critical part of pursuing any investment goal. Not only does this allow you to maintain your original target asset allocation, but it also can help you:

• Avoid rash reactions: Following a rules-based rebalancing strategy makes it easier to help prevent emotional interference in decision making that could lead to significant losses.
• Buy low and sell high: Instead of trying to time the market, rebalancing inherently sells out-performing assets and buys the under-performers (in hopes of growth down the line).
• Maintain diversification: Reweighting your portfolio involves buying and selling different securities to reduce the overall impacts of a specific asset class.

However, the act of rebalancing itself does come with potential drawbacks that you should be aware of – namely taxes and transaction costs:

• Capital Gains Tax: If you’re rebalancing your portfolio by selling a stock or bond at a profit within a taxable investment account, you’ll likely have to pay capital gains. While this can be unavoidable in some cases, rebalancing in tax-advantaged accounts, such as an IRA or 401k, does not expose you to these tax costs.

• Transaction Costs: Depending on your investment accounts, rebalancing might also incur transaction costs or even a commission fee. While trading costs are more common for a mutual fund or an exchange-traded fund, you might want to reconsider a financial advisor whose compensation is based on commissions.

While these drawbacks can lead to temporarily higher costs, the benefits of a regularly rebalanced portfolio can far outweigh these negatives in the long term. But what does “regularly” actually mean?

By regularly checking in on your investments, you can better manage your risk profile and revise your portfolio allocation should your risk tolerance or financial goals change.

Two popular approaches to rebalancing are:

1. Rebalancing by time
2. Rebalancing by percentage

When you rebalance by time, you pick a date on the calendar for when you will rebalance. Annual rebalancing is a common tactic for many people. Think of it like a yearly doctor’s appointment to check up on the health and performance of your assets. Many others choose to do it quarterly. Some employer retirement plans and funds also allow you to set up automatic target dates for rebalancing to simplify management.

The downside to this approach is that your portfolio may not need to be rebalanced on the date you choose. In fact, your allocations could get out of alignment at any time between the date of your last rebalance and your next – potentially exposing you to unwanted risk.

Rebalancing by percentage helps eliminates this problem.

When you balance based upon percentage, you start by setting up what are known as “drift parameters” for each asset class. These are the allocation thresholds that you don’t wish to exceed.

For example, you may decide that U.S. value stocks can make up as much as 28% of your portfolio or as little as 22%. If your allocation drifts past either of these thresholds, then it’s time to rebalance.

The advantages of this approach are twofold: You rebalance as soon as possible so that you reduce exposure to excess portfolio risk, and you only rebalance when needed.

This second point is particularly important if you are rebalancing a portfolio outside of a retirement account. Each time you sell an asset, you are potentially exposed to tax liabilities if there are any realized gains, and both buying and selling of assets can incur fees and commissions.

However, rebalancing by percentage also means that you have to watch your portfolio daily to make sure your asset allocation stays within your drift parameters. At Edelman Financial Engines, we eliminate that problem for our clients by actively monitoring their portfolios and rebalancing them by percentage whenever needed.

Another benefit of rebalancing is that it is responsive to the cyclical nature of the stock market and different asset classes. What this means is that as markets go through bullish and bearish cycles, some assets overperform while others underperform.

Rebalancing can help take advantage of this phenomenon.

For example, if bonds are up, you might sell some to bring your allocation back into balance. You might also need to buy some stocks that are down to hit the target allocation percentage. In that way, you sell high (the bonds) to buy low (the stocks). This also applies to other asset classes. When you rebalance, you sell some of the overperformers and buy some of the underperformers, which, when done regularly, may result in better control over your risks.

So, now that we know what rebalancing is, why it matters and when you should do it, you’re likely wondering how to begin.

Of course, a financial advisor can help walk you through the steps, but for the individual investor who wants to do it on their own, here’s how to rebalance your portfolio:

1. Get a portfolio overview: The first step to portfolio rebalancing should always be to create an accurate inventory of all your investments. Make a spreadsheet of all your accounts to understand the current distribution of your portfolio.
2. Analyze your holdings: Once you’ve obtained a comprehensive view of your investments, it’s time to examine your portfolio for asset allocation, overall risk, returns and any transaction costs.
3. Identify securities to sell: When you’re unloading investments from your portfolio, you’ll want to look for assets that are overweighted. These are generally your overperformers that cause your allocation to heavily favor a particular asset class. Selling these securities can help you correct these percentages to align with your original distribution.
4.  Redirect these funds: Selling alone isn’t always enough to rebalance a portfolio. To achieve your desired asset allocation, you might also have to move funds from the investments you sold into the classes you want to strengthen.

Throughout this process, you’ll need to keep your risk tolerance and financial goals in mind and update your portfolio to adjust for any changes. For example, if you recently inherited assets from a loved one, you will need to determine how they fit into your balanced portfolio and potentially have to sell some of them to maintain your target distribution.

As you rebalance your portfolio, you’ll likely need to pay capital gains tax on any earnings from taxable accounts. While some of these costs are inevitable, there are a few ways you can make your rebalancing strategy more tax efficient.

The easiest place to begin is your tax-advantaged accounts, such as a 401k, IRA or Roth IRA.

Another way to rebalance without paying taxes is to direct cash flows into underweighted asset classes in your taxable accounts. Let’s say, for instance, you’re a retiree who just received a required minimum distribution but you don’t need it right away. By investing this money into underweighted assets in your taxable account, you can rebalance your portfolio without having to sell anything.

Over time, you can further improve your tax efficiency by using rebalancing as a way to move investments into more tax-advantaged vehicles. Your financial advisor can help you determine which may be best for your specific financial situation, now and in the future.

Rebalancing is an important tool for maintaining your portfolio’s original asset allocation and keeping your risk profile in line with your overall risk tolerance. At the same time, it offers the flexibility to adjust your strategy should your goals or investing plans change.

At Edelman Financial Engines, we actively monitor the performance of our clients’ portfolios, rebalancing as needed to help them maintain an investment strategy that aligns with their goals.

Reach out to one of our financial planners today to see how rebalancing can help your portfolio.