- How To Rebalance Your Portfolio In 3 Easy Steps
- Who needs to rebalance?
- Who does not need to rebalance?
- Why do you need to rebalance?
- How do you rebalance your portfolio?
- 1. Review your ideal asset allocation
- 2. Determine your portfolio’s current allocation
- 3. Buy and sell shares to balance your portfolio
- What if you’re buying shares?
- How often should you rebalance?
- Consider rebalancing after big market movements
- Rebalancing makes my head hurt, how can I avoid this?
- Read more:
- How To Rebalance Your Investment Portfolio
- What Is Portfolio Rebalancing?
- Why You Need to Rebalance Your Portfolio
- When Should You Rebalance?
- How Do You Rebalance an Investment Portfolio?
- Ways to Minimize Taxes When Rebalancing
- Rebalance Your Portfolio Automatically with Robo-Advisors
- Final Thoughts on Rebalancing
- 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
How To Rebalance Your Portfolio In 3 Easy Steps
Every journey begins with a single step. If you’re new to investing, the most important thing is simply to get started.
If we were to compare investments to cars, a great investment portfolio would be a base-model Toyota Camry or Honda Civic. Boring? Perhaps. But it gets the job done, requires very little maintenance, and doesn’t cost a lot.
But even the most reliable car needs its oil changed regularly and will, occasionally, cough up a part that you’ll have to replace.
The same is true of even the best-designed passive-investment portfolios.
Every now and then you might recognize a “bad part”: an investment that no longer meets your goals or you should never have owned to begin with. And, once a year, you’ll need to change your portfolio’s oil, so to speak. This process is called rebalancing.
Who needs to rebalance?
Most investors who own stocks, bonds, mutual funds, or ETFs in any combination of retirement or taxable accounts.
Who does not need to rebalance?
You may not need to worry about rebalancing your portfolio if:
- All of your investments are held within a target date fund or another fund that automatically rebalances.
- All of your investments are within an automatically-managed investment account such as Betterment, Wealthfront, and others.
- You have a financial advisor who manages your investments for you.
Why do you need to rebalance?
A good investment portfolio is diversified among types of investments called asset classes. These include the largest classes of stocks, bonds, cash, real estate, and alternatives precious metals.
Going further, it’s also beneficial to diversify within each asset class. For example, the average investor wouldn’t want to own only US technology stocks; the safer bet would be to own a mix of domestic and international stocks across many different sectors.
If you’re already invested in mutual funds or ETFs, you already benefit from some diversification. But ensuring the funds you own provide the right allocation of asset classes and foreign vs domestic investments may still be up to you.
Read more: Understanding Asset Allocation for New Investors
How do you rebalance your portfolio?
There are three steps to rebalancing:
- Review your ideal asset allocation.
- Determine your portfolio’s current allocation.
- Buy and sell shares to rebalance your portfolio.
Let’s look at each step in detail.
1. Review your ideal asset allocation
Your ideal asset allocation—the right mix of stocks, bonds, and other asset classes in which to invest your retirement money—is a personal decision.
There are guidelines that can help you determine asset allocation, including a very simple rule in which you subtract your age from 100 to arrive at the percentage of stocks you should own (e.g., a 30-year-old should own 70% stocks).
These are controversial, however, and I would agree that they’re overly simplistic.
Choosing the right asset allocation involves weighing not only how long you have to invest but, perhaps more importantly, your appetite for risk.
Vanguard offers an 11-question survey that may be useful. It asks some behavioral questions about how you would react to market losses, as well as questions that speak to your investing experience.
Taking the survey, I ended up with an allocation of 80% stocks and 20% bonds. I just turned 35, so this is slightly more aggressive than the simple 100 minus age result of 75% stocks. That’s because my answers suggested I still have a very long time to invest and I’m fairly comfortable with riskier investments that stand to yield larger returns.
When I answered the same survey more conservatively, Vanguard returned an ideal allocation of 50% stocks and 50% bonds. The lesson? Choosing your asset allocation has as much, if not more, to do with your risk tolerance as it does with your age.
A good rule of thumb is this: If you tend to panic during market declines, such as the last month, or if you’ve ever sold losing investments that you planned to hold for a long time, you should consider a more conservative asset allocation, regardless of your age.
Important! For the purpose of this article, we’ll discuss asset allocations that are appropriate for younger investors who are still in the accumulation phase. That is, you’re earning money and investing more each and every year. Asset allocation gets more complicated (and critical, to some degree) once you’re retired and relying on your investments for income.
That said, the best allocation for your accumulation phase is the allocation that will allow you to leave your investments alone for 10 years or more and sleep at night.
2. Determine your portfolio’s current allocation
Once you know your ideal asset allocation, it’s time to figure out where your investments currently stand. Most investment accounts will include this information as part of their online dashboard. Here’s a screenshot of how it looks at Vanguard:
That’s useful if your investments are all in one place. But if you have, say, a 401(k) through work and an IRA on your own, you’ll need to determine the allocation of your entire portfolio.
Two helpful tools for this are Personal Capital and FutureAdvsior. Both are free. You link your investing accounts with the web apps and they’ll give you insights into your allocation.
FutureAdvisor goes so far as to give you the specific trades you’ll need to execute in order to rebalance your portfolio. For a fee, they’ll make the trades for you.
(Personal Capital stays free by offering premium investment advice for an annual fee.)
Special offer from Personal Capital: Get a FREE portfolio review valued at $799
If you want to determine your allocation on your own, I recommend a simple spreadsheet this one.
If you invest in mutual funds, you’ll need to research the funds’ investment holdings, which can be found in the funds’ prospectuses or via a research site Morningstar.
Whether you use a spreadsheet or an app, you’ll arrive at a difference between your existing allocation and your ideal. In the above example, this investor has 10% too much in bonds, 5% too much in other and is 15% under in stocks.
3. Buy and sell shares to balance your portfolio
This is where things get complicated, and one of the aforementioned apps can come in handy.
Basically, in order to bring your asset allocation in alignment with your idea, you’ll need to sell off investments that are overweighted in assets you want to reduce and buy investments in asset classes you want to increase.
To use a simple example, let’s say you own two index funds, both with balances of $5,000.
Vanguard Total Stock Market Fund—$5,000
Vanguard Total Bond Market Fund—$5,000
Total: $10,000 (100%)
So you have a 50/50 asset allocation. You’ve decided you want to be more aggressive and increase your asset allocation to 80% stocks and 20% bonds. To do that, you need to sell $3,000 of the Total Bond Market Fund and buy $3,000 of the Total Stock Market Fund, so that your resulting portfolio looks this:
Vanguard Total Stock Market Fund—$8,000 (80%)
Vanguard Total Bond Market Fund—$2,000 (20%)
Total: $10,000 (100%)
What if you’re buying shares?
Often times, you might decide to rebalance your portfolio at the same time you’re going to purchase more shares. In the above example, let’s say you want to arrive at an 80/20 allocation and are intending on investing an additional $2,000.
Your total portfolio will now be worth $12,000 and you’ll want it to include $9,600 in stocks and $2,400 in bonds. In this case, you would sell $2,600 of the bond fund, add it to the cash you currently want to invest and buy $4,600 in the stock fund. Your portfolio will then look this:
Vanguard Total Stock Market Fund—$9,600 (80%)
Vanguard Total Bond Market Fund—$2,400 (20%)
Total: $12,000 (100%)
How often should you rebalance?
For most young, long-term investors, rebalancing once a year should suffice. If you’re just talking about retirement accounts, it doesn’t really matter when you rebalance. Tax season is as good a time as any, especially if you make IRA contributions leading up to the April 15th deadline.
If, however, you own taxable (non-retirement) investment accounts, it’s a good idea to rebalance before the end of the calendar year to take advantage of tax-loss harvesting.
Without going into detail here – you can reduce your tax bill when you sell losing investments before the end of the year.
If you need to sell an investment to rebalance your portfolio and it’s lost money since you bought it, you can snag a bonus by harvesting the loss for tax reasons.
Consider rebalancing after big market movements
When a market goes up or down by 5% or more, your allocation will ly fall balance. So if you want to be more proactive, you might also consider rebalancing your portfolio anytime the markets move dramatically, such as the ups and downs we’ve seen this January.
Rebalancing makes my head hurt, how can I avoid this?
Rebalancing a complicated investment portfolio used to be a tedious exercise that made it attractive to have a financial advisor in your corner. But technology has come to the rescue – Personal Capital and FutureAdvisor being two that can make the task more manageable.
If you’re still wary, consider one of these robo-advisors, or what I to call automatically-managed investment accounts, for your IRA. These include Wealthfront, Betterment, and Acorns. With these companies, you set your asset allocation and they do the rest for you – automatically rebalancing and harvesting losses while you get on with your life.
Keep in mind, however, that a robo-advisor can’t help with your 401(k) or other employer-sponsored retirement account. If you’re the hands-off type, choose a target-date mutual fund in your 401k. These funds are pegged to the date you expect to retire and will automatically rebalance over time.
Rebalancing is an important part of long-term investing. Once a year, you should compare your investment portfolio to your ideal asset allocation – the right mix of stocks, bonds, cash, or other investments for your investment goals. Then make changes by selling and buying shares of investments to realign your portfolio to your desired target.
Free tools Personal Capital and FutureAdvisor can help. But if this sounds something you never want to worry about, consider working with a financial advisor or sticking to automatic investment accounts Wealthfront, Betterment,or Acorns.
- Asset allocation for young investors
- Target-date funds vs index funds
How To Rebalance Your Investment Portfolio
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Investing isn’t as simple as building a portfolio and just setting it on autopilot until retirement. You should be checking in on your investments from time to time for tune-ups, which investment pros call portfolio rebalancing.
Rebalancing your portfolio means buying and selling assets to help maintain the right level of investing risk you’re comfortable with. This not only keeps you on track to meet your goals, but it may also enhance your portfolio’s returns.
What Is Portfolio Rebalancing?
When you start investing, you begin by outlining your goals and choosing an asset allocation strategy to guide your purchases. This strategy balances the potential for high returns against the amount of risk you’re comfortable with. You’ll ly be buying both stocks to fuel growth and high returns, plus bonds for stability and income.
A long-term investment portfolio for retirement, for example, might have an asset allocation of 80% stocks and 20% bonds. But not all stocks are the same: The 80% in stocks might be subdivided into U.S. large company stocks, U.S. small company stocks and international stocks. wise, bonds may be divided between U.S. government bonds and corporate bonds.
As the investments that make up the portfolio change in value, the portfolio can drift away from your chosen asset allocation. While the plan might have been to invest 80% in stocks and 20% in bonds, for instance, that allocation made drift to 85% stocks and 15% bonds market returns, as the bonds you’ve purchased lose value and the stocks gain in value.
Rebalancing involves buying and selling mutual funds, exchange-traded funds (ETFs) or other investments to bring a portfolio back to its planned asset allocation.
Continuing the example above, you would sell 5% of your portfolio’s value in stock holdings and use the proceeds to purchase bonds.
This would bring the portfolio back in line with the planned asset allocation of 80% stocks and 20% bonds.
Why You Need to Rebalance Your Portfolio
Rebalancing is important for two reasons: risk management and improved returns.
An asset allocation plan is designed to accomplish two competing goals: optimal returns and minimal risk. Without rebalancing, many portfolios drift away from bonds and into more stock investments over time.
While this could increase the long-term returns of the portfolio, it will also add significant risk. This may, for example, make your portfolio’s highs higher and lows much lower.
Depending on your timeline, goals and ability to handle potential short-losses, this greater level of risk may derail your financial plans.
In addition to keeping your risk in check, rebalancing can actually improve your investing returns when you rebalance two or more asset classes that have similar long-term expected returns.
Rebalancing between small company funds, emerging markets and REITs, for example, may enhance your returns as you sell one that is performing well to buy more of another that is performing poorly now but has historically offered similar returns. In that case, you might be selling high and buying low, the ultimate goal with investing.
When Should You Rebalance?
There are two general approaches to how often you should rebalance your portfolio. The simplest approach is time. You might rebalance your portfolio once a quarter, once every six months or perhaps once a year. In addition to simplicity, this approach removes psychological factors that can cause investors to make changes in their portfolio during extreme market fluctuations.
The second approach—one recommended by many financial advisors—is to rebalance tolerance thresholds. For example, you might rebalance an asset class when its allocation deviates from the planned allocation by 20% or more.
Let’s assume a hypothetical asset allocation plan includes 10% in small-cap companies. Twenty percent of this allocation is 2%.
If you use a tolerance threshold, you’d rebalance when the small-cap asset allocation dropped below 8% or above 12%. In either case, the asset class would have drifted from the plan allocation by 20%.
If an asset class comprised 50% of a portfolio, you would rebalance when that asset class dropped below 40% or above 60%.
Using tolerance thresholds to rebalance a portfolio has several benefits. First, it’s an objective standard that, similar to a time-based approach to rebalancing, removes investors’ emotions from the decision.
Second, it rebalances the actual performance of a given asset class, not an arbitrary time period.
Finally, at least one study has shown that using a 20% tolerance threshold for rebalancing asset classes with similar expected returns can enhance the return of the portfolio.
How Do You Rebalance an Investment Portfolio?
The steps to rebalancing an investment portfolio are straightforward. First, identify those asset classes that have deviated from the planned allocation. If you’re using a tolerance threshold, you need to determine if an asset class has deviated enough to cross that threshold.
Second, sell investments in asset classes that exceed the planned allocation to bring them in line. Then use the proceeds from that sale to invest in those asset classes that have fallen below the allocation you want.
As part of this process, you should consider the tax implications of rebalancing.
If you’re rebalancing a tax-advantaged retirement account, an individual retirement account (IRA) or 401(k), you don’t need to worry about tax consequences because you don’t realize taxable gains within those accounts.
But if you’re rebalancing a taxable brokerage account, you should explore options to minimize unnecessarily selling high-performing (and therefore highly taxed) investments.
Ways to Minimize Taxes When Rebalancing
To minimize the potential tax consequences of rebalancing in a brokerage account, you have a few options. Tax-loss harvesting or adding new contributions to your account can both help minimize the impact of your rebalancing strategy.
Avoid capital gains taxes by using new cash contributions to purchase assets that bring your allocation into balance. This lets you decrease the percentage of one asset by investing a disproportionate amount into another asset until balance is restored. You can also use stock dividend or bond interest payments from your existing investments for rebalancing.
You may also choose to take advantage of any capital losses through a process called tax-loss harvesting to decrease the amount you may owe on gains you sell to rebalance the portfolio. This involves selling assets at a loss in order to offset capital gains tax liabilities.
You may not be able to completely rid yourself of capital gains taxes using these techniques. But they should help somewhat reduce your capital gains tax liability from rebalancing.
Rebalance Your Portfolio Automatically with Robo-Advisors
Investing with a robo-advisor is a great way to ensure your portfolio gets the regular rebalancing attention it needs with no extra effort on your part. Robo-advisors automatically rebalance your portfolio to keep you on track to meet your goals.
It’s important to note that most robo-advisors charge management fees, typically 0.25% of the funds they manage for you each year. At most major brokerages you could perform the same services for yourself at no additional cost, but you may decide that paying a small fee is worth your while to make your investing experience entirely hands-off.
Most major robo-advisors, Betterment and Wealthfront, include some level of tax-loss harvesting for clients, too.
Final Thoughts on Rebalancing
Rebalancing is an important part of managing an investment portfolio. Through rebalancing, you can keep the risk level of your portfolio consistent and perhaps even enhance your returns. When rebalancing, though, you have to be careful not to trigger excessive taxable income in taxable accounts.
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.