Like building a house, learning how to rebalance your portfolio begins with creating a sound foundation. First, define your financial goals, timeline, and risk tolerance. From this assessment, map out a mix of financial assets such as stock and bond ETFs with the help of a financial advisor or robo-advisor or on your own.
You’ll typically own a greater percentage of stock assets when you're younger, while more conservative investors will lean towards a larger allotment of cash and bond investments. We’ve compiled the basics every investor should know and have structured this guide for rebalancing your portfolio so that it should answer the most critical questions.
Key Takeaways
- Rebalancing your portfolio can minimize its volatility and riskand improve its diversification.
- You may run the risk of conflict with certain tax loss harvesting strategies.
- You can choose from several rebalancing strategies based on triggers from time spans to percentage changes.
- One option is to keep an eye on your actual and preferred asset allocation.
- Consider using a robo-advisor if you feel like you're a little over your head.
How to Rebalance Your Portfolio
The goal in rebalancing your portfolio is not perfection, since as soon as your investments return to their predetermined percentages, prices will shift, causing the asset values to deviate. Rebalance your portfolio at least annually and consider these factors:
- How much has my portfolio deviated from my original asset allocation?
- Am I still comfortable with my current asset allocation, or has my situation shifted suggesting that I amend the asset mix?
- Have my goals or risk tolerance changed?
Ways to Rebalance Your Portfolio
There are several rebalancing strategies:
- Select a percent range for rebalancing, such as when each asset class deviates 5% from its asset weight. The window of drift tolerance can be as low as 1 or 2% or higher than 5%. It all depends on the tolerance of the investor and the time they're willing to dedicate to keeping the portfolio compliant to the set allocation.
- Set a time to rebalance. Once a year is sufficient, although some investors prefer to rebalance quarterly or twice per year. There’s no wrong or right strategy, although less frequent rebalancing will potentially lead to greater stock allocations and higher overall returns, along with greater volatility.
- Add new money to the underweighted asset class to return the portfolio to its original allocation.
- Use withdrawals to decrease the weight of the overweight asset. If stocks have increased 1%, and you are removing funds from the portfolio, sell a portion of the overweight stocks and withdraw the proceeds.
Steps Needed to Rebalance Your Portfolio
First, track the asset allocation of your portfolio. You can maintain your records on a spreadsheet or use a free or paid investment monitor like Quicken or Mint. You're ready to proceed when your assets are listed and percent devoted to each asset class is recorded.
Step 1: Analyze
Compare the current percent weights of each asset class with your predetermined asset allocation. Quicken or other tools can do this for you. Or use a spreadsheet to compare your current asset values with the desired percent.
Step 2: Compare
Notice the difference between your actual and preferred asset allocation.If your 80% stock, 20% bond portfolio has drifted to 85% stocks and 15% bonds, then it’s time to rebalance, either by adding new money or selling stocks and buying bonds.
Step 3: Sell
To sell 5% of your stock assets, you’ll make a simple calculation. Assume your portfolio is worth $100,000 and your desired allocation is $80,000 in stock assets and $20,000 in bond assets. After the value drifts to $85,000 stocks and $15,000 bonds, you’ll sell $5,000 worth of stock investments.
Step 4: Buy
With the $5,000 proceeds from the stock sale, you’ll buy $5,000 of bonds. This will return your portfolio to its preferred 80% stock, 20% bond mix.
Step 5: Add Funds
Let’s say that you want to add $10,000 to the portfolio. The value of your portfolio will be $110,000 with a desired asset mix of $88,000 in stock investments and $22,000 in bonds. (Multiply $110,000 by 80% for the stock allocation amount and multiply $110,000 by 20% to arrive at your dollar goal amount for the bond category).
Step 6: Invest the Cash
To rebalance a portfolio after adding additional cash, calculate the difference between the current value and the preferred value, for each asset class. Using our former example, we have $85,000 in stocks so we buy $3,000 of stocks, to reach the desired $88,000 stock allocation. Similarly, we buy $7,000 of the bond asset class to reach the desired $22,000 in bonds.
Follow these steps every time you rebalance your portfolio and don’t worry if the asset allocation drifts between your rebalancing periods. If your situation changes, and you become more conservative or more comfortable with greater volatility or risk, you can always adjust your desired asset allocation.
How to Use a Robo-Advisor to Rebalance Your Portfolio
A robo-advisor might be the best solution for those who prefer to outsource portfolio selection and rebalancing. Robo-advisors such as Wealthfront and Schwab Intelligent Portfolios are designed to offer investors access to well-diversified investment portfolios, rebalancing, and other features, such as tax loss harvesting, with low or no management fees. The most popular robo-advisors administer a quick survey to determine your investment goals, timeline, and risk. Ultimately, the survey results drive the investment portfolio. After investing, the top robo-advisors will rebalance your holdings on an as-needed basis, to keep your portfolio in line with the initial survey parameters.
Pros and Cons of Portfolio Rebalancing
Investment management, which includes rebalancing, requires a commitment. You’ll need to analyze your investments, to make certain they still meet your objectives. Periodically you’ll review the asset allocation you’ve selected and decide whether you’re comfortable with the ups and downs of the financial markets.
You might choose to increase the stock allocation if you’re comfortable with greater risk, or increase the cash and bond portion if you’re nearing retirement or uncomfortable with occasional double-digit declines in your investment values.
Pros
Minimizes a portfolio's volatility and risk
Improves a portfolio's diversification
With a planned rebalancing schedule, you’re less likely to become spooked at a market drop and sell at the bottom
Cons
Opens the door to reducing portfolio exposure to outperforming sectors or adding to underperforming areas of the market
Has the potential for conflict with certain tax loss harvesting strategies
Assumes that you’ve chosen your own investments, which requires study and basic financial knowledge
Additional Tips to Rebalance Your Portfolio
Rebalancing is one component of the investment selection and management package. Here are additional tips to aid in successful rebalancing:
- Avoid checking your investment values too frequently (daily or weekly). This can lead to a sense that you need to act, which typically leads to overtrading and inferior investment returns.
- Create a personal investment policy statement, which includes your investment mix, asset allocation, and rebalancing parameters. Stick to your predetermined plan.
- In taxable accounts, look to minimize taxes. This involves selling losing positions to offset capital gains, or tax loss harvesting.
- Maintain a long-term focus. It’s easy to get distracted by frequent movements in your investments, but acting on those changes can short circuit your long-term goals.
Remember that investing is a way to turn today's earnings into future financial security.Investing and rebalancing are designed to increase your returns over the long term, such as five or more years. For shorter-term goals, consider a certificate of deposit or high-yield money market account.
Why Should I Rebalance My Portfolio?
Investors need a mix of higher-return stocks for growth and capital appreciation. But too many individual stocks or stock funds might make your portfolio too volatile. Stocks are more volatile than bonds and might increase 20% in one year and decline that amount or more in another. Bonds deliver lower returns and typically trade in a narrower range with smaller projected gains and losses than stock investments.
If you don’t rebalance and restore your assets to the 80% vs. 20% stock/bond mix and stocks become too large a portion of your portfolio, then you might experience a greater loss than you’re comfortable with on occasion. Rebalancing helps your investments stay on track to meet your financial goals.
How Much Does It Cost to Rebalance a Portfolio?
Most investment brokers don’t charge commissions or trading fees for stocks and ETFs. So buying and selling stocks and funds is typically fee-free. If you own individual bonds, you’re apt to pay a commission to buy or sell. Mutual funds might also levy a fee to trade.
As long as you’re buying and selling stocks or ETFs, the only fee you might incur is a tax on a capital gain, realized in a taxable brokerage account.
Can I Rebalance My Portfolio Without Selling?
Yes, you can rebalance your portfolio without selling. If you’re adding new money into the portfolio, buy the asset class that is underrepresented. If you buy enough shares, you can return the funds or individual holdings back to their preferred asset allocation. If you need to withdraw funds from your account, sell the overrepresented asset. You can also reinvest cash dividend payments into an under-allocated asset class.
Does Portfolio Rebalancing Reduce Returns?
Rebalancing reduces returns in most cases. Stocks have returned approximately 10% over the last century, so they'll become a greater percentage of the total portfolio over time without rebalancing. Stocks are also riskier and more volatile, so the growing stock allocation of the unbalanced portfolio will lead to higher returns, along with greater volatility. Rebalancing is usually a tradeoff between greater return and lower volatility.
How Often Should I Rebalance My Portfolio?
Rebalancing too frequently can sacrifice returns. Rebalancing less often can bolster returns and increase portfolio volatility. Vanguard recommends checking your portfolio every six months, and rebalancing if the values drift 5% or more from target. There isn’t a perfect rebalancing solution. The key is to set up a rebalancing schedule that works for you, create a reminder, and stick with it.
The Bottom Line
Rebalancing will keep your preferred asset allocation in check and help to smooth out the volatility of your portfolio. When stock prices soar, rebalancing will force you to take some profits. When prices are lower, and an asset class declines in value, you’ll buy at lower levels. Ultimately, the best way to rebalance is the strategy that works for you. Less frequent rebalancing saves you time and might allow your winning assets to grow for a bit longer.
