Why rebalance your portfolio? You’ve probably heard the term rebalance before as part of an investing discussion. It’s a basic concept used by financial professionals to maintain certain risk parameters around a portfolio. Without ever rebalancing a portfolio, the original asset allocation runs wild. For example, if an investor has a portfolio with 60% stocks and 40% bonds, over an extended period of time the stock portion of the portfolio will become more heavily weighted than the bond portion. This can be attributed to stocks being generally more volatile than bonds. If it was the investor’s original intention to maintain the risk associated with holding 60% stocks and 40% bonds, then the portfolio must be rebalanced at least annually back to its original allocation.
In essence, rebalancing is a tool used to create some certainty and automation around the investment process.
The Psychological Side of Rebalancing
Using rebalancing as an automation tool annually, semi-annually, or even quarterly helps investors stick to the rule. Regardless of what the markets doing or how their portfolio has performed, rebalancing automates a way to sell high and/or buy low. During a bull market, the investor continually sells securities at a gain and moves the money to underperforming securities to “rebalance” the portfolio back to its original allocation. Vice versa, during a market downturn, the investor continues to sell winners and buy losers in their portfolio. Without having this rule in place it can be exceedingly difficult to have the discipline to sell securities that have done well or to buy securities that have not.
As an investor, it’s a constant struggle to master our emotions. It’s not only one of the biggest barriers to entry for beginners, but also one of the biggest downfalls to even the most experienced investors. Having rules in place such as rebalancing helps take some of the emotion involved with investing out of the equation and ultimately helps the investor secure better returns in the long run.
Rebalancing Mistakes to Avoid
When it comes to rebalancing your portfolio, don’t make it more complicated than it needs to be. First, determine how often you will rebalance. Whether that’s based on a percentage of where your stock allocation has drifted or is calendar driven, if you have a rule in place it’ll work. Don’t become overly obsessive about when and how often you should rebalance, just stick to your rule.
Vanguard released a paper on best practices for portfolio rebalancing that showed the frequency at which an investor rebalances (monthly, quarterly, annually) had no material impact on the portfolio’s volatility. Meaning that rebalancing more often did not lead to better returns. Rebalancing once a year in most cases will do the job of managing risk, and helping returns in the long run.
When making trades in your portfolio, it’s always smart to remain cognizant of tax implications. Just because it’s time to rebalance, doesn’t mean you should sell a security with a large capital gain. Short-term capital gains (securities held for less than one year) are taxed at your income tax bracket, as opposed to long-term gains which are taxed at a much lower rate (0,15, or 20%). You may have losses to help offset some of the capital gains, however always be aware of any taxes you may trigger, especially if the security has a large gain.
The Bottom Line
Returning to our original question of why rebalance your portfolio, the answer is simple. Rebalance to keep your original asset allocation and risk in line with what you’re comfortable with. Ignoring your portfolio without making adjustments, will eventually transform it to become much riskier than you had originally intended. As a bonus, rebalancing also helps provide automation and discipline around the investing process. In turn, helping keep emotions in check, and allowing your portfolio to grow unimpeded by irrational behavior often caused during market downturns. Rebalancing should be a part of every investor’s long-term investment strategy.
If you’d like to discuss the amount of risk in your current portfolio, schedule a free consultation today.
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!