Rebalancing a portfolio means strategically selling one type of investment and buying another. Rebalancing your portfolio allows you to maintain a desired asset allocation over time, which is essential for balancing the risk you're taking with the long-term return potential of your investments. Rebalancing can consist of strategically selling investments and buying others in order to maintain an appropriate asset allocation, or it can consist of adding new funds and investing them in a strategic manner.
Although rebalancing is a relatively easy concept to understand, the mechanics of it aren't well understood by many investors. With that in mind, here's a thorough discussion of what every investor should know about rebalancing, including how often it should be done, how to do it, the financial implications of rebalancing, and the pros and cons that are important to know.
What does rebalancing mean?
In a nutshell, the purpose of rebalancing is to maintain a desired risk-reward ratio in an investment strategy. After rebalancing a portfolio, the original risk-reward profile of the portfolio should apply. In other words, if your original risk tolerance allowed you to invest 70% of your money in stocks in order to take advantage of their higher long-term gain potential, with the remainder in bonds, your rebalanced portfolio should bring this asset mix back once again.
In the context of investing, rebalancing means selling one or more assets and using the proceeds to buy another asset (or several) in order to achieve a desired asset allocation. Generally, rebalancing is used in the context of maintaining an appropriate stock and bond asset allocation in a brokerage account or retirement plan, but it can have other uses as well. For example, if a particular stock investment grows to the point of being too much of your portfolio, rebalancing can be a good idea in order to limit your single-stock risk. In other words, if you spread your money equally among 20 stocks and one of them soars by 1,000% (a good problem to have), it will now make up a large percentage of your portfolio. If one stock makes up too much of your portfolio, the future gains and losses of your portfolio will be disproportionately dependent on how that one stock does.
Why is rebalancing your portfolio important?
To show why rebalancing can be so important, consider this simplified example. Let's say that you invest $10,000 and that you put $6,000 of this into a S&P 500 stock index fund and the other $4,000 into a bond fund in order to obtain a 60%/40% stock and bond allocation.
Let's say that over the next five years, your stock investment doubles in value while the bond fund only gains 25%. Now your stock investment is worth $12,000 and the bond fund is worth $5,000. Your investment is now worth $17,000 -- a 70% gain -- so this is certainly a good problem to have, but it's still a problem.
The issue is that now your stock investments make up more than 70% of your total portfolio. You only wanted to have 60% of your money invested in stocks. In other words, your investment portfolio has become too reliant on the performance of your stock investments, and the whole point of asset allocation is to balance high-return, high-volatility assets (stocks) and lower-return but more predictable assets (bonds).
Asset allocation is extremely important, as it ensures that the risk and reward potential of an investment strategy is aligned with the investor's risk tolerance, time frame, and personal goals. However, if asset allocation isn't maintained over time by periodic rebalancing, you could find yourself with a portfolio whose risk-reward profile no longer meets your needs.
If you don't have a high risk tolerance -- say, if you're retired and can't handle large market swings -- an excessive stock allocation can be dangerous. As an example, if you have 50% of your money in stocks, a market crash can be easier to handle than if 80% of your portfolio is in stocks.
It's also important to mention that rebalancing isn't just necessary to maintain a proper overall asset allocation. Rebalancing can also ensure that your financial success isn't too dependent on any one stock, bond, fund, or other asset. In other words, if you own three stocks and one of them triples while the other two are even, the winning stock could end up making up an uncomfortably large portion of your portfolio.
Before you implement an investment strategy, such as deciding how to invest your retirement savings or deciding the best thing to do with some money you've been saving, a rebalancing plan can be just as important a component as determining your asset allocation or what your individual investments will be.
What is your current asset allocation?
When we're talking about brokerage accounts and retirement plans, there are typically three classes of assets that you can own -- stocks, bonds, and cash. Most brokers offer a way to view a breakdown of your asset allocation, usually on the home page or a click away from it. If not, or you can't find your asset allocation, here's a quick way to calculate it:
- First, write down your total account value.
- Second, add up all of your stock and stock-based investments. Equity mutual funds and ETFs fall into this category. Divide the result by your total account value and multiply by 100 to convert the result to a percentage.
- Repeat this step for bonds, and again for cash and equivalents such as money market funds and CDs.
As an example, let's say that you have $50,000 in your brokerage account. Of this, $30,000 is in stocks, $15,000 is in bonds, and $5,000 is in cash. Dividing each of these by the total and multiplying by 100 shows that your asset allocation is 60% stocks, 30% bonds, and 10% cash.
How to determine your ideal asset allocation
Unfortunately, there's no perfect method of determining your ideal asset allocation. Many financial planners -- myself included -- have a rule of thumb they like to use, but it's important to emphasize that even with a good rule, your personal situation must be considered.
My preferred method of determining your ideal asset allocation is to take your age and subtract it from 110 to determine your ideal stock allocation, with the remainder mostly in bonds. For example, I'm 37, so this means that about 73% of my portfolio should be in stocks, with the other 27% in bonds. I'm generally not a fan of keeping large amounts of cash equivalents as an investment until you're retired, but to be clear, this allocation formula is only referring to investment accounts. It's still a good idea to keep a cash emergency fund to help with unforeseen expenses.
However, after you apply this rule, consider your own situation. For example, if you consider yourself to be more of a risk-tolerant person and short-term market fluctuations don't bother you too much, it could be a good idea to shift your ideal allocation in favor of stocks. I consider myself to be in this situation, which is why I maintain an allocation that's closer to 80%/20%. On the other hand, if stock market swings keep you up at night, it could be a smart idea to err on the side of caution and allocate a little more to bonds or even to cash. After all, a higher potential return isn't worth sacrificing your own mental health!
When should you rebalance your portfolio?
Once you've determined your target asset allocation, the next logical question is "When should I rebalance?"
There are two general ways you can choose to do this. First, many investors like to rebalance their portfolios at set time intervals. In other words, maybe you could rebalance your investments every year on the same date, no matter how much your balance has changed.
Alternatively, you could choose to only rebalance your portfolio once it moves out of equilibrium by a certain amount. As an example, maybe you target a 70% stock allocation, so you might decide to rebalance only if your stock allocation drops below 65% or climbs above 75% of your portfolio. My problem with this approach is that there are often several market swings of 10% or more within any given year, and this can lead to excessive rebalancing.
A 2010 Vanguard report determined that the best course of action to maintain a desired risk-reward profile while minimizing rebalancing expenses involved monitoring the portfolio either annually or semi-annually and only rebalancing when the allocation is more than 5 percentage points away from the target. This way, you avoid excessive rebalancing in reaction to every single market swing and only do a periodic rebalancing if your portfolio is seriously out of alignment.
Rebalancing over time: Adjusting your asset allocation
There's another type of rebalancing that I would put into its own category. Over time, your desired asset allocation is likely to shift -- after all, most asset allocation rules of thumb are based on your age. This is a step beyond just rebalancing, as it involves a shift in your asset allocation strategy and is often referred to as reallocation.
Consider this example. Let's say that you're a typical 35-year-old and that your desired asset allocation is 75% stocks and 25% bonds, based on the "110 rule" I discussed earlier. Five years later when you're turning 40, your ideal allocation shifts to 70% stocks and 30% bonds. So even if your portfolio composition didn't change much over those five years, it's entirely possible that an age-based rebalancing could be a good idea.
How to rebalance your portfolio
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The basic idea behind rebalancing is simple: Sell some of your highest-performing investments and buy more of your lowest-performing investments. Recall our example from earlier, where $6,000 stock and $4,000 bond investments grew in value to $12,000 and $5,000, respectively. In order to rebalance to a 60/40 split, you'd need to end up with $10,200 in stocks and $6,800 in bonds.
So to rebalance, you'd sell $1,800 in stocks (or stock funds) and buy $1,800 in bond investments.
If you invest through a robo-advisory service or are trying to rebalance a retirement plan such as a 401(k), it's worth mentioning that many of these services offer an automatic rebalancing feature. You may even be able to set it up so that your account automatically rebalances at an interval of your choosing.
Back to the how-to discussion, while the standard way to rebalance is to sell some investments and buy others in order to restore your account's balance, there's an alternative that could be a better option if it's practical for you to do.
Instead of selling investments and buying others, you can potentially rebalance your portfolio by allocating new money strategically. Looking back to our previous example, if you had simply deposited $3,000 in your account and used it to buy bond investments, it would have resulted in you owning $12,000 in stocks and $8,000 in bonds, which would satisfy your desired 60%/40% split.
Now, I realize this isn't always practical, especially if you have a large investment account. For example, if a multimillion-dollar investment portfolio becomes considerably unbalanced, it can be impractical to simply deposit hundreds of thousands of dollars of additional funds in your account to attain the desired allocation. Even so, if you make steady deposits in your account, you could use those to help rebalance instead of solely relying on selling investments.
There are some key advantages to rebalancing this way. For starters, you can save yourself money in trading commissions. Instead of selling one investment and buying another (and paying two commissions), you can deposit money and make one transaction.
Furthermore, using new cash to rebalance could potentially save you money in capital gains taxes, as I'll get into in the next section.
And finally, one of the biggest drawbacks of rebalancing in the traditional way is that it involves selling your highest-performing assets. Rebalancing by contributing new funds to your portfolio lets you leave your winners alone to (hopefully) continue to outperform.
Tax implications of rebalancing
One of the major downsides of rebalancing your portfolio by selling assets and buying others is that by definition, you'll be selling your best-performing assets. As a result, rebalancing could potentially result in quite a capital gains tax bill.
Looking back at our example from earlier, where a $6,000 stock and $4,000 bond portfolio grew to $12,000 and $5,000, respectively, you'd have to sell $1,800 worth of stock and buy $1,800 worth of bonds in order to bring the allocation back to 60/40. However, remember that you're selling stock that doubled in value, so half ($900) of the stock sale would be considered a capital gain. If you are rebalancing a taxable (nonretirement) investment account, this could result in a hefty tax increase.
The mechanics of capital gains taxes are beyond the scope of this discussion, but if you've held the stock you sell to rebalance for more than a year, it could be taxable as a long-term capital gain, which gets favorable tax treatment. On the other hand, if you sell stock investments that you held for a year or less, your profits could be taxable as ordinary income.
For this reason, if you choose to do your rebalancing at a certain time interval, it can be a smart tax move to choose an interval that's greater than a year in order to avoid short-term capital gains taxes related to rebalancing.
Drawbacks of rebalancing
As I mentioned, rebalancing can have several key drawbacks. If you don't have enough money to add to your account to rebalance, you'll have to sell off your best-performing assets, you'll incur trading commissions, and you may face a hefty capital gains tax bill.
To be perfectly clear, the benefits of rebalancing outweigh these drawbacks. It's better to absorb the cost of a couple trading commissions than to leave your financial well-being overexposed to a single asset class. Even so, it's important to be aware that like most investing topics, there are pros and cons to rebalancing.
One big advantage for long-term investors
As a final point, one of the best consequences of rebalancing your portfolio over time is that it essentially forces you to do the best thing investors can do -- buy low and sell high.
For example, if the stock market crashes and equities fall by 30%, your bond allocation is likely to become too high. So rebalancing your portfolio could involve selling some of your bond investments and buying stocks while they're cheap.
Conversely, if the stock market rises to new record highs and beyond, bonds are likely to underperform. So you may find that when it comes time to do your periodic rebalancing checkup that your stock allocation has become too high and you'll need to sell some of your stocks at high prices.
It's human nature to do the exact opposite of "buy low, sell high." When markets plunge, it's our instinct to sell before things get any worse. And when stocks can seem to go nowhere but up and we see everyone else making money, that's when we want to put our money into the market. Establishing and sticking to a good rebalancing plan can help you avoid this type of emotionally charged behavior.
The key takeaways on rebalancing your portfolio
Here's a quick summary of what investors should know about rebalancing:
- Rebalancing your portfolio allows you to maintain your desired level of risk, even after major market fluctuations.
- There's no one-size-fits-all way to determine your ideal asset allocation, but you should consider your age, time horizon, and personal financial goals when establishing yours.
- You can rebalance your portfolio at predetermined time intervals, when your allocation has deviated a certain amount from your ideal stock/bond mix, or a combination of the two.
- Rebalancing can be done by selling one investment and buying another or by allocating new funds to the lagging investment type.
- If you sell investments to rebalance, plan for trading costs as well as potential tax implications.
- Rebalancing encourages you to put money into stocks when they're cheap and to sell when they're expensive.
To sum it up, periodic rebalancing is an important part of a disciplined investment strategy and can help you keep your long-term investment strategy at an appropriate risk level and return potential.
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