5 Factors to Consider When Rebalancing Your Portfolio

Maximizing returns is a key goal for any investor, but maintaining a well-balanced portfolio is just as important for managing risk and ensuring long-term success. Over time, market fluctuations can shift your asset allocation, potentially exposing you to more risk than you intended. That’s why periodic rebalancing is essential. Before making any adjustments, however, it’s crucial to evaluate five key factors that can help you optimize your portfolio while staying aligned with your financial goals.

A financial advisor can help you build your portfolio or rebalance it.

5 Factors to Consider When Rebalancing Your Portfolio

1. Your Asset Allocation

Rebalancing is the process of adjusting your investments to return to the asset allocation you’re most comfortable with. Your asset allocation is the mix of securities in your portfolio based on your risk tolerance. For example, if you’re very risk-averse, it’s best to have mostly bonds and cash in your portfolio.

Over time, the percentage of stocks, bonds and cash investments that you have will shift automatically as certain securities outperform others. Maybe stocks made up only 20% of your portfolio when you first started. However, because the ones you chose are doing well, they now make up 40% of your assets. When you rebalance, you’ll need to sell some of those high-performing equities and buy other assets so that stocks make up only 20% of your portfolio again.

After rebalancing your portfolio, you may not achieve the same returns, at least in the short term. However, chasing returns is not the point of rebalancing. It’s important to rebalance from time to time to avoid excessive risk. Even if all of your stocks have high return rates right now, their values could fall.

2. How Frequently You’ll Rebalance

Next, you must decide how often you will rebalance. That’ll depend on your investment goals.

Failing to rebalance your portfolio can put you in a risky position. However, rebalancing too often or in response to economic conditions can be just as dangerous if it means you’re paying high fees and taxes.

You can rebalance periodically, such as quarterly, every other month or a couple of times a year. Either way, it’s best to rebalance whenever your portfolio drifts too far from your asset allocation or when your plans change. For example, you may need to become a more conservative investor because you’ve decided to retire early.

3. Your Rebalancing Threshold

You can’t determine how frequently you’ll rebalance unless you choose a rebalancing threshold. That’s a percentage that represents how far your assets have strayed from your asset allocation.

Will you rebalance if your portfolio weights are 1% off? Or will you wait to rebalance when they’re 5% or 10% off? Those are questions you’ll have to answer based on your circumstances.

A financial advisor can help you find the right reallocation strategy.

4. The Costs of Rebalancing

Before you buy or sell, you must ensure you can afford to rebalance. Can you cover the fees you may have to pay upfront when purchasing a new asset or selling one you already have?

It’s also a good idea to review the expense ratio of the securities you’re interested in. This will tell you the percentage of your assets that are going toward management fees.

Besides the financial consequences of rebalancing, you must remember that the process can be somewhat time-consuming. It’ll take longer than a few minutes to complete the process, so be sure to make enough room in your schedule to rebalance properly.

5. How Rebalancing Will Affect Your Tax Bill

It is critical not to forget about the tax implications of rebalancing. You won’t owe taxes for switching out securities in your 401(k) or IRA, since they’re tax-deferred. If you have taxable accounts, however, you’ll pay capital gains taxes when you sell an asset and its value has increased since you bought it.

To minimize your tax liability, you can use tax-loss harvesting. That means you’ll sell off your low-performing securities to offset your capital gains.

You also have the option to wait a while before selling an asset. Short-term investments are taxed at a higher rate than those you hold onto for more than a year.

Rebalancing in Different Account Types: Where to Start

If your portfolio spans multiple account types, the order in which you rebalance matters as much as the rebalancing itself. Starting in the wrong place can trigger an unnecessary tax bill even when the overall strategy is sound.

Tax-Advantaged Accounts

Tax-advantaged accounts like IRAs and 401(k)s are generally the best place to begin.

Gains within these accounts are either tax-deferred or tax-free. Therefore, you can buy and sell holdings to restore your target allocation without creating a taxable event in the current year.

This makes them the most flexible accounts for making significant adjustments, particularly if your allocation has drifted substantially.

Taxable Brokerage Accounts

Taxable brokerage accounts require more care.

Every sale of an appreciated asset in a taxable account generates a capital gain, adding a direct cost to rebalancing.

However, adjustments to taxable accounts are sometimes unavoidable. In this case, prioritizing the sale of assets held for over a year keeps gains at a lower long-term capital gains rate rather than the higher short-term rate. Tax-loss harvesting, selling positions that are down to offset gains elsewhere, can also reduce the net tax impact of rebalancing in taxable accounts.

Two approaches can help you rebalance without selling anything at all, regardless of account type.

Using underweight asset classes. The first is directing new contributions toward underweight asset classes rather than spreading them proportionally. Over time, this gradually shifts the balance back toward your target without triggering any sales.
Avoiding automatic reinvestment. The second is redirecting dividends and interest payments away from automatic reinvestment and toward whichever asset classes need to grow.

Neither approach works as quickly as selling and buying directly. However, both can move the portfolio in the right direction while minimizing the tax and fee costs of getting there.

The general principle is to exhaust your options in tax-advantaged accounts first. Then, use contributions and dividends to close any remaining gap before turning to taxable accounts as a last resort.

How to Rebalance Your Portfolio

Rebalancing your investment portfolio is a crucial process to maintain your desired level of risk and return.

Over time, market fluctuations can cause your asset allocation to shift. This can potentially expose you to more risk than originally intended. Rebalancing helps realign your portfolio with your financial goals by adjusting the weightings of different asset classes, such as stocks, bonds and cash.

You can rebalance your portfolio in a few steps.

Review your target asset allocation. Start by using the SmartAsset asset allocation calculator to determine your ideal allocation. This will be based on factors like your risk tolerance, time horizon and investment objectives. For example, a balanced portfolio may consist of 60% stocks and 40% bonds.
Assess your current portfolio allocation. Check your holdings to see if they have deviated from your target allocation. Over time, certain assets may have grown significantly, while others may have underperformed, causing an imbalance.
Identify assets to buy or sell. Compare your current allocation to your target allocation. If stocks have grown to 70% of your portfolio instead of the intended 60%, you may need to sell some stocks and reinvest in bonds or other assets to restore balance.
Determine a rebalancing strategy. Multiple rebalancing strategies may help, such as selling overweight assets, using new contributions and dividend reinvestment adjustments.
Consider tax implications and fees. Selling investments may trigger capital gains taxes, especially in taxable accounts. Be mindful of tax-efficient rebalancing strategies, such as prioritizing adjustments in tax-advantaged accounts like IRAs or 401(k)s. Also, consider trading fees and advisor commissions.
Execute the rebalancing process. Once you’ve decided on your adjustments, make the necessary trades to bring your portfolio back in line with your target allocation.
Monitor and set a rebalancing schedule. Rebalancing is not a one-time task. Set a schedule to review and rebalance your portfolio periodically — such as quarterly, semi-annually or annually — to ensure it remains aligned with your goals. Some investors rebalance when their asset allocation drifts beyond a specific threshold, such as a 5% deviation.

Rebalancing your portfolio is a disciplined approach to maintaining a well-diversified investment strategy that aligns with your financial goals.

By periodically reviewing and adjusting your asset allocation, you can manage risk effectively and keep your investments on track. Whether you rebalance manually or use automated tools, staying proactive in managing your portfolio can lead to better long-term financial outcomes.

Bottom Line

Rebalancing involves selling some assets and buying others to maintain your target asset allocation. When it comes to investing, there’s no hard rule on how often you should readjust your portfolio. By accounting for these financial factors, you can use rebalancing to your advantage while minimizing overall risk.

Tips for Portfolio Management

A financial advisor can manage your portfolio and rebalance as needed. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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