- Rebalancing–How to Create a Plan to Easily Rebalance Your Investments
- Asset Allocation Recap
- Frequency & Threshold
- What’s best for you?
- Rebalancing annually or semi-annually is usually fine
- Should I Rebalance My Portfolio?
- What Is Asset Allocation Rebalancing?
- Benefits of Rebalancing
- Rebalancing Alternatives
- Use New Money As Part of Your Rebalancing Strategy
- Rebalance Within Tax-Deferred Accounts
- Offset Capital Gains and Losses
- Automatic Rebalancing
- Have a Plan and Stick to It
- Don’t Lose Your Balance: When and Why to Rebalance Your Portfolio
- What Does Rebalancing A Portfolio Mean?
- When Should Investors Consider Rebalancing?
- How to Rebalance Your Investment Portfolio
- Find Your Balance – And Keep it
- Rebalancing Your Portfolio
- Rebalancing Approaches
- Automatic Rebalancing with Lifecycle Funds
Rebalancing–How to Create a Plan to Easily Rebalance Your Investments
Rebalancing your investment portfolio is an important part of managing your money. Having carefully selected your asset allocation, rebalancing ensures that your investments stay in line with the allocation you’ve chosen.
In this article (and podcast) we cover creating a rebalancing plan. We’ll cover topics such as how often to rebalance (frequency) and what to rebalance (threshold). In the podcast to follow, I’ll walk through the specific steps you can take to actually rebalance your portfolio.
- Asset Allocation Recap
- Approaches to rebalancing
Asset Allocation Recap
If you’re up to speed on asset allocation, you know that it’s all about deciding how much you want in stocks, bonds, and cash. These asset classes can be further sub-divided. Stocks can include U.S and foreign stocks, small cap stocks, emerging markets, and so on.
Bonds may include U.S. and foreign bonds, government and corporate bonds, as well as munis and TIPS. There are also alternative asset classes, such as REITs (Real Estate Investment Trusts) and commodities.
When you’re investing, you decide ahead of time – before you even pick your mutual funds – what you want your asset allocation to look . There’s no one-size-fits all answer to this question. You need to do your research, and then decide what’s right for you.
For today, let’s assume that you’ve chosen to invest 70% of your retirement money in stock mutual funds and 30% in bonds. So you start out with that exact allocation. But as the prices of stocks and bonds move up and down with the market, your portfolio will drift away from that original allocation.
You may find a few months or a year down the road when you look at your accounts, that you no longer have 70% in stocks. Maybe now you have 75% in stocks, which means that you now only have 25% in bonds. Rebalancing is nothing more than correcting this imbalance by returning your portfolio to its original 70/30 allocation.
This raises three questions, the first two we’ll cover today:
- How often should you rebalance your investments?
- How far from your asset allocation plan should you allow you investments to drift before rebalancing?
- When it’s time to rebalance, how do you actually do it? (That’s in podcast episode 052.)
The first is frequency. You simply decide that you’ll balance your portfolio every month, every three months, once a year – however often makes sense for you. Large pensions sometimes rebalance daily.
For most individual investors who go this route, rebalance once or twice a year is sufficient.
With this approach, you rebalance regardless of how much your asset classes have drifted from your target asset allocation plan.
The second approach is threshold. In other words, there’s no particular time involved. It’s simply that you’ll rebalance when your various asset classes drift by a certain amount. For instance, using our 70% stocks/30% bonds portfolio, you may set a threshold of 5%. So you’ll rebalance when either asset class gets more than 5% away from its original starting point.
If stocks rise to 75% of your portfolio or bonds rise to 35%, you’d rebalance. The downside to this approach is that you have to check your asset allocation frequently to know when you’ve crossed the threshold.
You may not have to check it daily, but you’ll need to check weekly or monthly if there are lots of ups and downs in the market. You’ll also have to check your portfolio more frequently if you set a lower threshold.
Frequency & Threshold
The third approach is the one I use. This combines both frequency and threshold. You decide that you’ll check every month, quarter, year, or whatever. But you only rebalance your portfolio if it passes a certain threshold when you do check it.
In my case, I look at my portfolio monthly, which is probably excessive. But since I enjoy it and blog about it, that’s a habit I’ve fallen into. But I don’t rebalance until my portfolio reaches the 5% threshold. So if my stock allocation is 80% and my bonds are 20%, I’d have to see stocks go above 85% or below 75% before I’d rebalance.
What’s best for you?
There’s no one right answer as to which rebalancing approach you should use. But you should take some things into consideration as you’re deciding what plan is best for you.
First, you need a rebalancing plan. Whether you take the frequency approach, the threshold approach, or the combination approach, you need to know ahead of time when you’ll rebalance. A plan is important because without one, you’ll be tempted to let the market dictate your rebalancing strategy..
For example, the S&P 500 Index was up more than 32% in 2013. Without a plan, many investors would be unly to move investments from stocks to bonds during such a bull run, even if their stock allocation was significantly overweighted. Similarly, when the stock market is down 30%, it can be very hard to move assets from bonds to stocks. Following a plan helps you do the right thing.
Second, consider cost. It may cost you money to rebalance, which we’ll talk about in the next podcast and article. So as you think about what approach you want to use for rebalancing, think about costs.
For instance, if you trade investments in a taxable account to balance your portfolio, that could trigger significant taxes. Also, you’ll have to pay fees, sometimes, when you rebalance.
Typically in a 401(k), there won’t be any fees to buy and sell mutual funds. (But you need to confirm that with your plan administrator.
) With IRAs and taxable accounts, there could be fees, depending on where you have your accounts and whether you’re investing in individual stocks or ETFs.
Finally, there’s a time aspect to all of this. You may have a 401(k), and your spouse may have a 401(k), and you could have multiple IRAs and taxable accounts. It’s a real headache to rebalance, and that’s worth considering. A more simple strategy is often best.
For all these reasons, I think that rebalancing once or twice a year is probably enough for most people – with or without a threshold. You have to decide what’s right for you, but it’s worth thinking about the money, time, and energy involved in this process.
Rebalancing annually or semi-annually is usually fine
The Vanguard white paper, “Best Practices for Portfolio Rebalancing,” evaluates going back to 1929. What the authors conclude is that, for most investors, it’s perfectly fine to rebalance either annually or semi-annually with a threshold of about 5%.
In other words, once or twice a year you’ll look at your investments, and if they’ve moved away from your asset allocation plan by more than 5%, you’ll rebalance.
What Vanguard found is that you could do this monthly or quarterly, but when looking at data over long periods of time, it doesn’t significantly decrease the risk in your portfolio.
And even if you want to focus on returns, instead of risk, rebalancing monthly versus quarterly or annually won’t have a significant difference in returns.
So for most people, this frequency and threshold option is a good approach. Check your portfolio once or twice a year, and if you get whack by more than 5%, rebalance.
Now I should add this: if you have a more complicated asset allocation plan, this may be a bit different. For instance, if you have 10% in REITs, it’s unly that they’re going to fall to 5% or rise to 15%.
So what I’d do in that case is to look at a change of 25% of that 10%. In other words, in case of an asset class where I’ve allocated 10% of my investments, I’ll look for that asset class to move one way or another by 2.5% (25% * 10%).
So if it goes down or comes up by 2.5%, I’d rebalance.
Should I Rebalance My Portfolio?
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Unless you're a day trader, you shouldn't micromanage your investments or even check them on a daily basis. But on the flip side, investing is not a hands-off endeavor, either.
Investing is about more than just selecting some individual stocks, mutual funds or ETFs and letting them ride. One important aspect for most investors is selecting an asset allocation and periodically rebalancing back to that allocation.
What Is Asset Allocation Rebalancing?
Asset allocation is the percentage of your portfolio allocated to various types of investments or asset classes. Broad asset classes include stocks, bonds and cash. Sub-asset classes include things small cap stocks, foreign bonds and a whole multitude of investment types and classifications.
Let's look at a simple example of an asset allocation model a $100,000 investment.
Our investor uses three Vanguard mutual funds and is looking for a 65% allocation to stocks and 35% to bonds. The initial portfolio looks this:
|Vanguard Total Stock Market (VTSAX)||45%|
|Vanguard Total International Stock (VTIAX)||20%|
|Vanguard Total Bond Market (VBTLX)||35%|
After a significant runup in the stock market, the allocation might look this:
|Vanguard Total Stock Market (VTSAX)||57%|
|Vanguard Total International Stock (VTIAX)||28%|
|Vanguard Total Bond Market (VBTLX)||15%|
This could expose the investor to significantly more downside risk than the original allocation.
In order to bring the portfolio back in line with the target allocation, he will want to rebalance it back to the original target allocation.
Benefits of Rebalancing
Rebalancing offers several benefits for investors:
• The process of reviewing your portfolio and accounts on a periodic basis instills a form of discipline on investors. You may or may not need to do any rebalancing at that time, but reviewing your portfolio periodically is a good exercise. • Rebalancing is a way to control portfolio risk.
• Rebalancing can help you keep your portfolio on track with your overall financial plan.
If you need help figuring out how to rebalance your portfolio, you can use a service Personal Capital. And right now if you qualify, you can get a FREE portfolio review from Personal Capital worth $799.
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The most common way to rebalance is to sell holdings in asset classes that are over-allocated and then use the proceeds to beef up your allocation in asset classes where you are currently under-allocated.
Be careful, though. Depending upon the types of investments used, this can trigger transaction costs for buying and selling.
Additionally, for money held in a taxable account, these transactions could trigger capital gains or cause you to realize capital losses. This is not a reason to avoid rebalancing, but you should be aware of the tax implications. There may be other ways to do some or all of the needed rebalancing to consider.
Use New Money As Part of Your Rebalancing Strategy
If you contribute regularly to a 401(k) or other workplace retirement plan, adjust your contributions to direct them to asset classes where you are under-allocated. (Investor Junkie has reviewed a service, called Blooom, that was created to help with this.)
wise, if you are contributing to an IRA or to a taxable account, direct those dollars to these asset classes.
This might not solve the entire problem, but it can help get your portfolio back in line.
Rebalance Within Tax-Deferred Accounts
Trades made within tax-deferred accounts such as a 401(k) or IRA will not be subject to any tax consequences. Therefore, you don't have to stress out about the potential for any capital gains tax.
Offset Capital Gains and Losses
For taxable accounts, it's important that you understand where all of your holdings stand in terms of unrealized capital gains and losses.
If you need to realize a gain on the sale of a holding, try to sell holdings where the capital gains would be considered long term. This means that the fund, ETF, etc., has been held for at least a year and a day.
Long-term capital gains are taxed at a preferential rate. This rate may be lower than your marginal tax bracket for ordinary income.
Wherever possible, try to use any holdings where you would realize a loss to offset any potential capital gains. This can take the sting rebalancing.
Remember, these losses can also be used to offset capital gains arising from mutual fund or ETF distributions. Losses in excess of any gains can be used to offset other income up to an annual limit of $3,000.
Unused losses can be carried forward to subsequent tax years.
Automatic rebalancing can make this task easier. This feature is offered by many 401(k) plans and other types of workplace retirement plans, as well as many robo advisors.
In a 401(k) setting, you would generally set a regular interval for your account to be rebalanced back to a set allocation. Annually or semi-annually are usually good choices. You probably don't want to do this with any more frequency than quarterly.
Even if you use automatic rebalancing, you can still go in and make changes manually if needed or desired.
Remember, if you do set this up, it covers only the applicable accounts. You will want to review your overall asset allocation to be sure that your entire portfolio is properly allocated across all accounts.
Have a Plan and Stick to It
During a rising stock market, the temptation might be to let your winners ride. Maybe you will be lucky, and this will work out for you. Or more ly, it won't.
You aren't smarter than the stock market. Have a plan and stick to it. Set limits for how far (up or down) your allocations can stray from a target percentage of your portfolio.
Review your portfolio at regular intervals and rebalance when needed.
Don’t Lose Your Balance: When and Why to Rebalance Your Portfolio
Everyone invests for a reason. When you sat down with your financial professional for the first time, the questions you answered helped to set you off on a path towards the financial future you had envisioned. Your financial professional put together a plan to find the right balance of risk and return to meet your needs.
Whether it be to work towards broader long-term goals paying a child’s college tuition, a new home, or a relaxing retirement, or more specific short-term milestones you’d to hit along the way a rental property or a boat.
Since you walked that first meeting with your investment plan and its corresponding target asset allocation, things have changed. Even if your financial priorities haven’t shifted, your portfolio ly has.
Markets are always moving. They may trend up or down over a long period of time or periods of volatility can result in large short-term swings in value. No matter where they are trending, the shifting winds of financial markets can carry your portfolio to unintended places.
How then, can you ensure you remain on the path your financial professional set for you? Especially with the end of the year in sight, it may be time to restore your balance.
What Does Rebalancing A Portfolio Mean?
Rebalancing a portfolio is the process of restoring the weightings of portfolio assets to their original desired levels.
The balance within your portfolio was chosen carefully and specifically by your financial professional to help you maintain the right amount of risk and expected returns necessary to give you the best chance at achieving your primary financial objectives.
Consider a simple hypothetical portfolio, established in 2015, with a target allocation consisting of 60% stocks and 40% bonds.
After only three years, this portfolio is exposed to more equity risk than their financial professional determined was suitable for their client’s goals. A downturn in equity markets would result in a larger drop in overall portfolio value than it would at the original target allocation of 60%.
It is time to rebalance.
When Should Investors Consider Rebalancing?
When it comes time to rebalance a portfolio for the first time, it is good practice to establish a regular frequency to revisit in the future as a means of staying on track.
There are inputs to consider in the rebalancing process, namely transaction costs and potential tax considerations when realizing capital gains or losses.
For most investors, rebalancing once per year is appropriate.
Additionally, your financial professional may set thresholds for your various allocation targets and trigger a rebalance when your portfolio drifts beyond them. For example, in our hypothetical portfolio of 60% stocks and 40% bonds, the financial professional may set a threshold of 65% stocks. When the portfolio values shift beyond that figure, the rebalancing process would begin.
It is common practice for financial professionals to implement a combination of these two strategies. For example, a financial professional may set allocation thresholds and an annual rebalance review date. Should your portfolio become unbalanced before the chosen date next year to the extent that it trips a threshold, your financial professional would begin to rebalance then.
How to Rebalance Your Investment Portfolio
When your financial professional designed a portfolio for you, he or she gathered information about your unique financial situation and put together a target asset allocation suited for your goals.
In order to restore the balance of your portfolio at a later date, you will need to keep a record of the strategy created for you. Important things to include are the total cost of each security, total value of each asset class, and total value of the portfolio.
You will need these values to compare against at a later date.
On the date you have scheduled your annual rebalance, it will be time to review the value of your portfolio and the individual asset classes against the records you made.
You can calculate your asset class weights by dividing their current value by the new total value of your portfolio. Have the weightings changed materially from your original targets? If not, you do not need to rebalance at this time.
If they have changed significantly, it is time to move forward with rebalancing.
If your portfolio review reveals that your asset class weightings have shifted away from the targets laid out in your investment plan, your financial professional will begin the process of rebalancing. There are a few different ways that he or she can proceed to make the changes.
Your financial professional may simply sell excess securities in asset classes over your thresholds and transfer the money to underweight asset classes. They may also reinvest profits from winning trades over time into lagging asset classes, for example stock dividends may be collected and used to fund bond purchases.
Finally, you can always direct any new money into the lagging asset classes if you are investing a portion of your paychecks or bonuses.
Find Your Balance – And Keep it
One of the most important concepts in investing is the principle of asset allocation. The mix of assets in your portfolio is integral to staying on track when it comes to pursuing investment objectives, but it does not end with your first meeting with your financial professional.
Periodic check-ins on your portfolio’s movements over time are vital to ensure that the plan your financial professional made for you is still in place.
By creating a rebalancing plan and sticking to it, you give yourself the best chance to keep your balance and continue your pursuit of your long-term investment goals.
To learn more, please contact your financial professional.
Rebalancing Your Portfolio
As market performance alters the values of your asset classes, you may find that your asset allocation no longer provides the balance of growth and return that you want. In that case, you may want to consider adjusting your holdings and rebalancing your portfolio.
Assets grow at different rates—which means that your portfolio might end up line with the allocation you have chosen. For example, some assets might recently have grown at a much faster rate.
To compensate, you might reallocate some of the value of fast-growing assets into assets with slower recent growth, which may now be poised to pick up steam while recent high-performers slow down.
Otherwise, you might end up with a portfolio that carries more risk and provides a smaller long-term return than you intended.
Although there’s no official timeline that determines when you should rebalance your portfolio, you may want to consider whether you need to rebalance once a year as part of an annual review of your investments.
The Cost of Shifting
Keep in mind that account shifting means potential sales charges and other fees. Aside from the costs you might incur, switching investments when the market is doing poorly means locking in your loss.
If this occurs in a taxable account, you may be able to take a tax deduction. However, if you are rebalancing in a retirement savings account a 401(k), you can’t take a tax deduction on capital losses.
Also, be aware that if your investments have increased in value, selling them to rebalance your portfolio in a taxable brokerage account could result in your having to pay capital gains taxes. For more information, see our article on cost basis.
You can rebalance your portfolio in different ways to bring it back in line with the allocation balance you intend it to have. Here are three common approaches to rebalancing:
- Redirect money to the lagging asset classes until they return to the percentage of your total portfolio that they held in your original allocation.
- Add new investments to the lagging asset classes, concentrating a larger percentage of your contributions on those classes.
- Sell off a portion of your holdings within the asset classes that are outperforming others. You may then reinvest the profits in the lagging asset classes.
All three approaches work well, but some people are more comfortable with the first two alternatives than the third. They find it hard to sell off investments that are doing well in order to put money into those that aren't. Remember, though, that if you invest in the lagging classes, you'll be positioned to benefit if they turn around and begin to prosper again.
Automatic Rebalancing with Lifecycle Funds
The asset allocation you choose to help you meet your financial goals at an earlier time in life may no longer be the ideal allocation after you've been investing for some time, for instance as you approach retirement.
Or, many investors, you may simply never take the time to modify your allocations, or feel confident doing so. And so you might end up doing nothing.
That's where lifecycle funds, also called target date funds, come in. These funds are increasingly being offered in retirement plans, and are also available to investors outside of retirement plans, too. Each lifecycle fund is designed to have its allocation modified gradually over a period of years, shifting its focus from seeking growth to providing income and preserving principal.
Usually, this is accomplished by reducing your exposure to stocks and increasing the percentage your lifecycle fund allocates to bonds. To make matters simpler, a fund's timeframe is often part of its name. So, in 2015, if you're thinking of retiring in about 15 years, you might put money into Fund 2030.
And if your target retirement date is 30 years away, you might choose Fund 2045. Before transferring your balances to a lifecycle fund, you'll want to investigate the fund as you would any potential investment, looking at its objective, fees, manager, historical performance and risk levels, among other details.
If it passes those tests, it may be an alternative to consider.
Also keep in mind that lifecycle fund managers may be making allocation decisions assuming that this is your sole investment. Take the time to evaluate lifecycle funds relative to your overall investment portfolio.