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.
1. Your Asset Allocation
Rebalancing is the act of switching up your investments to get back to the asset allocation you’re most comfortable with. Your asset allocation is the mix of securities you have 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, but because the ones you chose are doing well, they now make up 40% of your assets. When you rebalance, you’ll need to sell off some of those high-performing equities and buy other assets so that stocks only make up 20% of your portfolio again.
After rebalancing your portfolio, you might not end up with the same returns, at least in the short term. But chasing returns is not the point of rebalancing. It’s important to rebalance from time to time to avoid having too much risk. Even if all of your stocks have high return rates right now, their values could fall.
2. How Frequently You’ll Rebalance
Now that you know what rebalancing is, you’ll need to decide how frequently you’ll do it. That’ll depend on your investment goals. Never rebalancing your portfolio can put you in a risky predicament. But rebalancing too frequently or in reaction to what’s happening in the economy can be just as dangerous if it means you’re paying a lot in fees and taxes.
You can rebalance periodically, such as quarterly or every other month. Or you can rebalance 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 more of a 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. If you need assistance, you can always contact a financial advisor.
4. The Costs of Rebalancing
Before you buy or sell a single security, you’ll need to make sure you can afford to rebalance. Can you cover the fees you might have to pay upfront for purchasing a new asset or selling off one you currently have? It’s also a good idea to look at the expense ratio of the securities you’re interested in. That tells you what percentage of your assets are going toward management fees.
Besides the financial consequences of rebalancing, you’ll need to remember that the process could be somewhat time-consuming. It’ll take longer than a few minutes to finish, so you’ll need to make room in your schedule to rebalance.
5. How Rebalancing Will Affect Your Tax Bill
Along the same lines, you don’t want 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 capital gains tax bite, you can use tax-loss harvesting. That means you’ll sell off your low-performing securities to offset your capital gains. Or you can wait a while before selling an asset. Short-term investments are taxed at a higher rate than the ones you hold onto for more than a year.
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, potentially exposing you to more risk than you 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. Below are the key steps to effectively rebalance your portfolio.
- Review your target asset allocation: Begin by identifying your ideal asset allocation based on 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 current portfolio holdings to determine 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: There are multiple ways to rebalance, including 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 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 choose to rebalance when their asset allocation drifts beyond a certain threshold (e.g., 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 ensure that your investments remain 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 off some assets and buying others to make sure you’re hitting your target asset allocation. When it comes to investing, there’s no hard rule on how often you should readjust your portfolio. By taking the factors we’ve mentioned into account, you’ll be able to use rebalancing to your advantage and minimize your 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.
- An investment calculator could help you estimate how your portfolio assets might grow over time.
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