Over time, market fluctuations can cause your investment portfolio to drift from its intended mix of stocks, bonds and other assets. Regularly rebalancing your portfolio involves selling high-performing assets and buying underperforming ones to maintain your target allocation. This disciplined approach can help manage risk and optimize returns, keeping your investment strategy on track. If you need help managing and rebalancing your portfolio, consider working with a financial advisor.
How Portfolio Rebalancing Works
Portfolio rebalancing is a tactic aimed at maintaining a specific asset allocation. The performance of different assets within a portfolio can vary over time and cause the portfolio to drift from its original allocation. For example, if a portfolio initially has a 60/40 allocation of stocks to bonds, strong performance in the stock market could shift this balance to 70/30. Rebalancing involves adjusting the portfolio back to its target allocation to align with the investor’s risk tolerance and investment goals.
The rebalancing process typically involves selling assets that have increased in value and buying assets that have decreased. This might seem counterintuitive, as it involves selling high-performing assets and purchasing those that have underperformed. However, rebalancing can help an investor maintain a desired level of diversification within their portfolio and reduce the chances that they’re overexposed to a specific type of asset. Rebalancing can be done periodically, such as quarterly or annually, or when the allocation deviates by a certain percentage from the target.
Investors can rebalance their portfolios manually through financial advisors or automatically through robo-advisors. Manual rebalancing requires the investor to actively monitor their portfolio and make the necessary trades. In contrast, automatic rebalancing is managed by algorithms that adjust the portfolio based on predefined criteria.
Why Rebalancing Is Important
Investors often hear about the importance of diversification, but rebalancing a portfolio is one of the ways in which an investor can pursue diversification.
Over time, the performance of different assets can cause your portfolio to drift from its original allocation. This drift can expose you to unintended risks or reduce potential returns. By regularly rebalancing, you realign your investments with your financial goals and risk tolerance.
One of the primary reasons to rebalance is risk management. As certain assets outperform others, they can take up a larger portion of your portfolio, increasing your exposure to a single asset class or sector. For example, if stocks perform well, they might grow to represent a higher percentage of your portfolio, raising your overall risk. Rebalancing ensures that you do not become overly dependent on any single investment, maintaining a balanced risk profile that aligns with your long-term strategy.
Rebalancing also enforces a disciplined investment approach. By selling high-performing assets and buying underperforming ones, you follow the classic investment advice of “buy low, sell high.” This can help mitigate the emotional biases that often lead to poor investment decisions, such as chasing past winners or panic-selling during market downturns. Ultimately, regular rebalancing can enhance the stability and performance of your portfolio, helping you stay on track to meet your financial objectives.
Portfolio Rebalancing Strategies
There are three primary approaches to rebalancing a portfolio: a calendar-based approach, a target threshold-based approach and a more dynamic strategy called constant proportion portfolio insurance. Each method has its unique advantages and considerations, which can significantly impact an investor’s strategy.
Calendar-Based Rebalancing
The calendar-based approach to rebalancing involves setting specific dates to review and adjust your portfolio, regardless of market conditions. Common intervals for this method include monthly, quarterly, semi-annually or annually. This approach is straightforward and can help investors avoid the emotional decision-making that often accompanies market volatility.
Simplicity is one of the main advantages of the calendar-based approach. By adhering to a set schedule, investors can systematically review their portfolio’s performance and make adjustments without overreacting to short-term market fluctuations. This method also allows for easier planning and can help in managing transaction costs, as rebalancing occurs at predetermined times.
Although, the calendar-based approach has its drawbacks. It may not be responsive enough to significant market movements that occur between scheduled rebalancing dates. Consequently, an investor’s portfolio could drift further away from its target allocation, potentially increasing risk or missing out on opportunities for gains. Despite this, for those seeking a disciplined and easy-to-implement strategy, the calendar-based approach can be highly effective.
Threshold-Based Rebalancing
The threshold-based approach, also known as the percentage-of-portfolio approach, triggers rebalancing based on specific deviation thresholds. Instead of rebalancing at set intervals, investors adjust their portfolios when asset allocations deviate from their target by a predetermined percentage, such as 5% or 10%.
This method is more dynamic than the calendar-based approach, as it responds to actual market movements and the performance of individual investments. By rebalancing only when necessary, investors can potentially reduce transaction costs and minimize the impact of taxes, particularly in taxable accounts. The threshold-based approach can also help investors maintain their desired risk level more accurately, as it quickly addresses significant deviations from the target allocation.
However, the threshold-based approach requires more active monitoring and management, which can be time-consuming for individual investors. Additionally, frequent trading to maintain target allocations may result in higher transaction costs, particularly in volatile markets. It also demands a solid understanding of market conditions and investment principles, making it more suitable for experienced investors or those working closely with a financial advisor.
Constant Proportion Portfolio Insurance (CPPI)
Constant proportion portfolio insurance (CPPI) is a dynamic rebalancing strategy that aims to provide downside protection while allowing for potential upside gains. It works by maintaining a constant proportion of the portfolio’s value in risky assets (like stocks) and a safer asset (like bonds or cash) to ensure a predefined floor value, which is the minimum value the portfolio should not fall below.
The strategy involves regularly adjusting the allocation between the risky and safe assets based on the portfolio’s current value and the distance to the floor. This approach is designed to offer a balance between growth and capital preservation, making it suitable for investors who seek to protect their investment from significant losses while still participating in market gains.
One significant drawback is the cost associated with frequent rebalancing. The strategy requires continuous monitoring and regular adjustments to the asset allocation, which can lead to high transaction costs and potential tax implications. Additionally, CPPI’s reliance on maintaining a floor value may result in conservative asset allocations during prolonged market downturns, limiting the potential for recovery and growth when markets rebound.
How Often Should I Rebalance My Portfolio?
When it comes to maintaining a healthy investment portfolio, regular rebalancing is important. However, the question of how often one should rebalance can be complex, depending by individual goals, market conditions and the specific assets within a portfolio.
Your investment goals and time horizon play a significant role in determining how often you should rebalance. If you have a long-term investment horizon, such as saving for retirement, you might not need to rebalance as frequently. On the other hand, if your goals are short-term, you may need to rebalance more often to ensure your portfolio remains aligned with your objectives.
Market conditions can greatly affect your rebalancing strategy. During periods of high market volatility, your portfolio’s asset allocation can drift significantly from your target allocation. In such times, more frequent rebalancing may be necessary to manage risk and maintain your desired asset mix. Conversely, in stable market conditions, less frequent rebalancing might be sufficient.
Many investors find it beneficial to combine both fixed intervals and threshold-based rebalancing. For example, you might schedule a review of your portfolio every quarter but only execute rebalancing if the asset allocation has shifted beyond your pre-set thresholds. This hybrid approach can offer the best of both worlds, ensuring regular oversight while being responsive to significant market changes.
Taxes and Costs of Rebalancing
Frequent rebalancing can incur transaction costs and potentially trigger capital gains taxes, which can eat into your returns. It’s essential to weigh these costs against the benefits of rebalancing. Using tax-advantaged accounts like IRAs for frequent rebalancing activities can help mitigate some of these current tax implications.
Capital gains taxes are one of the most significant costs associated with rebalancing. When you sell an asset for more than you paid for it, you realize a capital gain, which is subject to taxation.
Assets held for a year or less are subject to short-term capital gains tax, which is typically higher than long-term capital gains tax applied to assets held longer than a year. Short-term gains are taxed at your ordinary income tax rate, while long-term gains benefit from reduced rates.
When rebalancing, you also may incur various transaction costs, including:
- Brokerage fees: Every time you buy or sell securities, your broker may charge a fee. These fees can add up, particularly if you rebalance frequently.
- Bid-ask spread: This is the difference between the buying price (ask) and the selling price (bid) of a security. When you trade, you often buy at the higher ask price and sell at the lower bid price, resulting in a cost.
Rebalancing can also involve opportunity costs, which are the potential benefits you forgo from not investing in a different asset. For example:
- Missed market opportunities: Selling a high-performing asset to rebalance your portfolio might mean missing out on future gains if that asset continues to rise.
- Holding cash: During rebalancing, you might temporarily hold cash, which typically earns lower returns compared to other investments. This can reduce your overall portfolio performance.
How to Minimize Rebalancing Costs
Here are some options for minimizing or eliminating the taxes and fees associated with portfolio rebalancing:
- Use tax-advantaged accounts: Conducting rebalancing within tax-advantaged accounts, such as IRAs or 401(k)s, can help avoid capital gains taxes, but those gains will be taxed at regular income tax rates on withdrawal.
- Threshold rebalancing: Instead of rebalancing on a fixed schedule, you can rebalance only when your asset allocation deviates significantly from your target. This can reduce the frequency of trades and associated costs.
- Use of dividends and contributions: You can use dividends or new contributions to purchase underweighted assets rather than selling overweighted ones. This strategy helps maintain your target allocation without incurring transaction costs or capital gains taxes.
Bottom Line
Portfolio rebalancing is a disciplined strategy that helps investors maintain their desired asset allocation, manage risk and optimize returns over time. By regularly adjusting your portfolio to its target mix, you can navigate market fluctuations more effectively and stay aligned with your financial goals. Whether you choose a calendar-based approach, threshold-based method, or a combination of both, rebalancing requires careful consideration of costs, tax implications and market conditions.
Asset Allocation Tips
- Selecting a mix of stocks, bonds and cash can help you diversify your portfolio and reduce risk. SmartAsset’s asset allocation calculator can recommend a mix of stocks, bonds and cash according to your risk tolerance. Those recommendations even include a percentage breakdown of how much of a portfolio may be invested in small-, mid- and large-cap companies, as well as international and emerging markets.
- A financial advisor can help you create an asset allocation strategy for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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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