When to rebalance your portfolio?

You and your planner spent a lot of time choosing your portfolio, which is likely a specific combination of stocks and bonds designed to help you achieve your long-term financial goals at your desired risk level. Yet, you may be wondering what the impact to your portfolio is when one investment position grows much larger than the other or when there is heightened market volatility like we’ve seen recently. 

The answer? Stock and bond positions can drift away from their intended targets, changing your portfolio’s original risk/return profile.

THIS IS WHY PORTFOLIO REBALANCING YOUR PORTFOLIO IS IMPORTANT

How can you keep your portfolio’s allocations near their percentage targets? Through rebalancing. 

“Rebalancing your portfolio is key to managing overall portfolio risk through any market environment,” says Edelman Financial Engines planner Andrew Band, director, financial planning. It stands to reason that rebalancing requires selling positions that are over their targets to add to other positions that have dropped below theirs. Rebalancing an allocation that has risen in value can result in capital gains taxes. Taxable accounts may have slightly more room to drift to help avoid capital gains. However, you should monitor all of your portfolios for rebalancing, regardless of whether they are taxable or nontaxable accounts, so portfolios remain within their risk parameters.

This proactive review helps buffer against the uncertainties of volatile market conditions, helping show any deviations from the intended asset mix is promptly corrected. Additionally, this careful approach aids in maintaining an investor's desired exposure to different market sectors, which can significantly influence long-term financial outcomes. By adopting such meticulous rebalancing practices, investors can ensure that their investment strategy remains aligned with their financial objectives, even as market dynamics shift.

“We don’t want to be rebalancing too frequently, as that could trigger an unnecessary tax event,” says Edelman Financial Engines planner Phil Wilson, director, financial planning. “We seek to rebalance portfolios in a way that helps keep the client’s investment mix optimized,” Wilson said. 

CAPITAL GAINS EVEN DURING A DOWN MARKET

Keep in mind that during a down market, a portfolio can experience capital gains due to rebalancing. Not all securities will necessarily decline in a bear market, and most portfolios should be highly diversified across many stocks and bonds. This diversification plays a significant role in mitigating risk while providing potential opportunities for gains. For instance, certain sectors or assets may perform better than others during economic downturns, which can allow astute investors to capture these gains through strategic rebalancing.

By maintaining a diversified portfolio, investors can ensure they are not overly exposed to the volatility of a single asset class, which helps smooth out returns over time. Understanding that capital gains in such conditions are a natural outcome of active portfolio management is crucial, as they signify that parts of your investment are indeed appreciating in value. This underscores the importance of regularly reviewing and adjusting investments to align with market conditions and individual financial goals, helping ensure portfolios remain robust even in challenging markets.

“Capital gains taxes are a natural part of successful investing,” says Wei-Yin Hu, vice president of financial research and strategy. “While you don’t want to have large capital gains taxes, not having any capital gains may mean your investments aren’t growing,” Hu adds. 

DAILY REBALANCING VS. MONTHLY OR QUARTERLY REBALANCING?

In today's financial landscape, monitoring is essential for maintaining a portfolio within its prescribed risk parameters, especially during periods of heightened market volatility. Sudden and unpredictable changes in the market can result in stock and bond indexes fluctuating considerably in just a couple of trading sessions. This unpredictability underscores the importance of frequent rebalancing to help ensure that investments do not deviate too far from their desired allocations, potentially exposing investors to unwanted risks.

By reacting swiftly to these market shifts, investors can better safeguard their portfolios against the erosive effects of volatility, ultimately supporting their long-term financial objectives. It's a proactive strategy that not only preserves capital but also exploits opportunities that arise amid market turmoil. Such agility in investment management can significantly enhance the resilience and performance of a diversified portfolio, particularly in times when market movements are rapid and unpredictable.

If rebalancing were only to occur monthly, or even quarterly, your portfolio could theoretically drift further and further away from its risk/return profile for an extended period during the month or quarter. Your portfolio would not be serving your long-term goals during that time. 

“We believe that rebalancing based on portfolio shifts and market volatility, rather than set calendar periods, is a critical part of delivering the outcomes that clients seek,” Band says. 

When our Investment Management team determined the allowable percentage drift for our portfolios, they carefully balanced the need to retain portfolio risk parameters with exposing accounts to additional costs, such as taxes for nonqualified accounts as well as trading costs. The percentage drifts we allow have at times changed because we are always monitoring and seeking to improve our investment processes to enhance client outcomes. 

Generally, in volatile markets you may see a need for more rebalancing, and in quiet markets, less. When stocks and bonds move in different directions, there may also be a need for more rebalancing. 

If you have any questions about how rebalancing, don’t hesitate to contact a Edelman Financial Engines planner. We are here for you.