Investing is not a "set it and forget it" endeavor. While a well-thought-out investment strategy is essential for achieving long-term financial goals, the dynamic nature of the market necessitates ongoing attention and action. One of the key practices that can enhance investment outcomes and help maintain alignment with financial objectives is rebalancing. This guide will explain what rebalancing is, why it matters, and how it can benefit your portfolio.
What Is Rebalancing?
Rebalancing is the process of realigning the weightings of assets within a portfolio. This typically involves buying or selling assets to maintain a desired asset allocation, which reflects the investor's risk tolerance, time horizon, and financial goals. Over time, different investments grow at different rates, causing the original asset allocation to drift. For example, if stocks outperform bonds, a portfolio initially set up as 60% stocks and 40% bonds may shift to 70% stocks and 30% bonds. In this scenario, rebalancing would involve selling some stocks and buying more bonds to return the portfolio to the original 60/40 split.
Why Is Rebalancing Important?
- Maintaining Risk Levels
Asset allocation plays a crucial role in determining a portfolio’s risk profile. As certain assets outperform others, the portfolio can become more heavily weighted in higher-risk categories. Rebalancing ensures that your investment portfolio remains consistent with your risk tolerance. Without it, you may end up with a portfolio that is either too risky or too conservative, potentially jeopardizing your financial goals.
- Capitalizing on Market Opportunities
When you rebalance, you are essentially following the "buy low, sell high" strategy. This involves selling assets that have appreciated (and are now relatively more expensive) and buying those that have underperformed (and are now cheaper). Over time, this can add value to your portfolio by taking advantage of market fluctuations.
- Enhancing Discipline and Reducing Emotional Investing
Rebalancing helps investors stick to their investment strategy rather than making impulsive decisions based on market swings or emotions. It enforces a disciplined approach to investing, requiring you to periodically review and adjust your portfolio based on your long-term objectives rather than reacting to short-term volatility.
How Often Should You Rebalance?
There is no one-size-fits-all answer to how frequently you should rebalance your portfolio, but common approaches include:
- Time-based rebalancing
This method involves rebalancing at regular intervals, such as quarterly, semi-annually, or annually. It's simple and ensures you review your portfolio periodically.
- Threshold-based rebalancing
With this approach, you rebalance whenever the allocation of an asset class deviates from the target by a certain percentage (e.g., if your allocation to stocks exceeds your target by more than 5%).
- A combination of both
Some investors choose to check their portfolios regularly (e.g., quarterly) and rebalance only if the deviation exceeds a specified threshold. This approach can help balance the benefits of frequent monitoring with the discipline of making changes only when necessary.
The Costs and Considerations
While rebalancing is beneficial, it’s important to understand the associated costs and considerations:
- Transaction Costs
Frequent buying and selling can incur transaction fees, although these costs have decreased significantly in recent years due to the rise of low-cost trading platforms. Still, it’s wise to weigh the costs against the benefits, especially for smaller accounts.
- Tax Implications
Rebalancing in a taxable account may trigger capital gains taxes. Strategic rebalancing, such as using tax-advantaged accounts for adjustments or offsetting gains with losses, can help mitigate this impact.
- Time and Effort
Monitoring your portfolio and executing trades requires time and effort. Some investors prefer to automate the process through rebalancing services or target-date funds, while others may enlist the help of a professional wealth manager.
The Benefits in Practice
To illustrate the benefits of rebalancing, consider two portfolios with an initial allocation of 60% stocks and 40% bonds:
- Portfolio A: No rebalancing occurs over a decade.
- Portfolio B: Rebalanced annually to maintain the 60/40 allocation.
Assuming the stock market performs well during this period, Portfolio A may end up with a much higher allocation to stocks, potentially 75% or more, thereby increasing its risk profile beyond what the investor originally intended. Portfolio B, on the other hand, would have systematically taken profits from stocks during their periods of strength and reinvested in bonds, maintaining a consistent risk level.
Over time, this disciplined approach can help smooth out returns, reduce risk, and improve the chances of reaching long-term financial goals.
When Rebalancing May Not Be Necessary
While rebalancing is generally advantageous, there are circumstances where it may not be needed as frequently:
- When using all-in-one funds or managed accounts
These investment options may already incorporate automatic rebalancing.
- If you have a small portfolio in tax-advantaged accounts
Rebalancing may have a minimal impact on a smaller, diversified portfolio.
Key Takeaways
Rebalancing is an essential practice for maintaining your investment strategy's integrity, reducing risk, and potentially enhancing returns. While the process involves some effort, the long-term benefits of staying disciplined can far outweigh the costs. Regularly reviewing your portfolio and making adjustments as needed helps you stay on track to achieve your financial goals, ensuring your investment approach remains aligned with your evolving needs and market conditions.