As the markets seesaw up and down, the way your money is distributed among different types of investments and asset classes can change. Over time, these changes may increase or decrease the risk of your portfolio. As a result of these changes, it could be time to rebalance your portfolio.
What is rebalancing?
The purpose of rebalancing is to move a portfolio back to its original target allocation by following the first rule of investing: Buy low and sell high. Rebalancing is the process of selling a portion of your portfolios over weighted investments, and using the proceeds to buy more of your underweighted investments until the percentage of each asset is equal to the original portfolio.
Once you have built a well-diversified portfolio, you may need to rebalance it periodically to ensure that it continues to match your investment goals and objectives. Taking the time to rebalance your portfolio will ensure that your investment goals are still on track. If you don’t rebalance and one asset class in your portfolio becomes too large, you are, by default, changing your portfolio’s risk profile.
For example, let’s say you own two funds: Fund A and Fund B. You have a $100,000 portfolio and have selected an asset allocation such that each fund represents 50% ($50,000 each) of the total. The following year, Fund A gains 20% while Fund B loses 20%. Your portfolio’s value hasn’t changed and is still worth $100,000. However, the difference in the performance of the two funds causes the allocation of your portfolio to change from a 50-50 mix to 60-40. As a result, the portfolio now has different risk and return characteristics than its original allocation. To return to your desired 50-50 allocation, you would rebalance your portfolio by taking $10,000 from Fund A (sell high) and invest it into Fund B (buy low).
Most investors understand the concept and logic of rebalancing. However, the counterintuitive logic of rebalancing often leads investors to do the complete opposite. Emotionally, they want to buy more of the investments that have recently made the most money (buy high), and sell more of the investments that have lost and/or made the least amount of money (sell low). From a long-term, wealth-accumulation standpoint, this is exactly opposite of what investors should do.
Rebalancing accomplishes three important objectives:
1. Guarantees you will buy low and sell high.
2. Removes your emotions from the investing process.
3. Keeps your portfolio’s asset allocation in line with your risk profile
There can be tax consequences to rebalancing, depending on what type of account your money is invested in. Rebalancing (i.e., selling an investment) in a tax-deferred account, such as a 401(k) or an IRA, is not a taxable event. The only time you pay taxes in a tax-deferred account is when you withdraw money from the account. Unlike tax-deferred accounts, whenever you rebalance (sell) an investment that has appreciated in value in a taxable account, non-IRA or 401(k), you could owe taxes from capital gains
How often should you rebalance?
There are various theories about the best ways and time to rebalance. Just as there is not one perfect asset allocation, there is not one perfect rebalancing strategy.
At a minimum, rebalancing should be performed once per year. At Capital Wealth Management, we review each client’s portfolio every month to see if rebalancing is needed. Our investment policy dictates rebalancing when a client’s individual target asset allocation is out of balance by plus or minus 5%.
For instance, if a client’s portfolio has a target allocation of 60% stocks and 40% bonds, this method rebalances if stocks reach either 65% or 55%, and bonds make up 35% or 45% of the portfolio.
Rebalancing is an important part of long-term investing. Portfolio rebalancing can help reduce downside investment risk, and ensures that your investments are allocated in line with your financial plan. A year-end review with your financial adviser is an ideal time to review your portfolio’s allocation and rebalancing options.
Martin Krikorian, is president of Capital Wealth Management, a registered investment adviser at 9 Billerica Road, Chelmsford. He can be reached at 978-244-9254, www.capitalwealthmngt.com, or via email email@example.com.