Different investments earn different rates of return, and over time your allocation will become unbalanced. Thus, you will want to review your portfolio periodically and make adjustments to rebalance it.
While rebalancing is easy enough to understand, it is often a difficult concept for investors to implement. Rebalancing goes against your basic instincts. With rebalancing, you are basically selling those investments that are performing well in favor of those that are underperforming. It might help to remember that you are following a basic investment principle when rebalancing: you are buying low (underperforming investments) and selling high (well-performing investments).
A few thoughts on rebalancing:
Rebalance at least annually. Rebalancing too frequently can be counterproductive and may result in excess costs in the form of short-term redemption fees on mutual funds or frequent trading commissions for individual stocks or ETFs. Generally, rebalancing semi-annually or annually works well. Choose a date to rebalance—perhaps at the beginning of the year, when you receive your annual statements, or at the end of a quarter. On this date, compare your current allocation to your target allocation. If your current allocation is off by more than the limits specified in your financial plan, then rebalance back to the target allocation for that asset class.
Rebalance when your allocation differs from your target allocation by a designated percentage. At the preselected rebalancing interval, review your overall portfolio by asset class. Ideally, your investment policy has a target allocation percentage and an acceptable range for each investment style. For example, your target allocation for large-cap domestic stocks might be 25 percent, with a range of 20 to 30 percent. So if the percentage allocation is between 20 and 30 percent, you do not need to rebalance.
If the allocation is right at the high or low end of the band, you may or may not want to bring it back to the target. This is where you may decide to be a bit tactical in your rebalancing based on your outlook for a particular investment style. For example, if your bond allocation is at the lower end of your target range and your personal outlook for bonds is poor, then you might want to allow this allocation to stay at the lower end of the range. Should the allocation fall below the lower end of the range, however, you will want to rebalance enough to at least bring the allocation back within the target range.
Rebalance regardless of current market conditions. Many investors abandoned their asset allocation during the 2008–9 market downturn largely based on fear. In many cases, they bailed out of equities altogether. Many did this near the bottom of the market and have never gotten back into the market. These investors suffered the cruelest of all fates: they booked large losses, and because they stayed largely or totally out of the market, their portfolios did not recover as part of the torrid market rally off the March 2009 lows. As tough as it might be to stomach losses, if you have a long-term plan that includes an investment strategy, try to stick to it and rebalance at regular intervals.
Once you’ve decided what needs to be rebalanced, you need to implement those changes. If the change is within a tax-deferred account, such as a 401(k) plan or individual retirement account, it can typically be made without tax ramifications. With taxable accounts, you’ll want to consider the tax ramifications before implementing the change.
If the sale of an asset will result in a tax liability, consider other methods to implement the change. For instance, new investment dollars can be directed to the underweighted portion of your portfolio, or periodic interest, dividends, or capital gains distributions can be redirected to the underweighted portion.
Regardless of whether periodic rebalancing might trigger some tax consequences, reviewing and rebalancing your investments is vital. Markets change, often swiftly and violently, as we saw in 2008–9. Periodic rebalancing forces you to take some of your gains off the table. Many investors are good at picking investments for purchase. Far fewer have a sell discipline.
Roger Wohlner, CFP® is a fee-only financial advisor at Asset Strategy Consultants. Roger provides advice to individual clients, retirement plan sponsors and participants, foundations, and endowments. Follow Roger on Twitter; connect with him on LinkedIn.