How To Rebalance Your Portfolio

 Mirah Gocher

May 25, 2018

Rebalancing is the process of buying and/or selling assets to adjust the weights of investments in a portfolio. The purpose of rebalancing your portfolio is to align your investments with your optimal allocation strategy in order to reach your financial goals. Your investment strategy should be established before you start investing and should be based on personal factors such as your risk tolerance, age, and future goals.

There are a wide variety of suggestions and tools for allocating assets across your portfolio,  but it ultimately comes down to your own personal comfort taking risk. One rule of thumb for someone with lower risk tolerance is that your bond allocation should be roughly equal to your age.  For example, a 30-year old would target 30% bonds and 70% equities, while a 50-year old would target 50% bonds and 50% equities.

Why Should You Rebalance Your Portfolio?

Similar to an annual checkup with your doctor, a rebalancing of your portfolio ensures that everything is in working order.  As time passes, the returns on assets from your investments can vary greatly and result in a portfolio that is allocated differently than your initial strategy.  Rebalancing also allows an investor to lock in the positive returns of their well-performing assets while purchasing investments that have gone down in price.

When Should You Rebalance Your Portfolio?

Unlike your annual checkup, your portfolio likely doesn’t need to be updated on a yearly basis.  In fact, rebalancing a portfolio should be done as infrequently as possible, due to the trading costs and tax implications associated with buying and selling portions of your portfolio. One way to decide an appropriate time to rebalance is if any asset class in your portfolio is off by more than 5-10%.

One very important thing to remember is that it is easier and cheaper to rebalance your portfolio over time with new investments than it is to sell stocks and bonds you already own. This more gradual approach to rebalancing a portfolio and can be financed through distributions from existing investments such as dividends, coupon payments, and/or new contributions being allocated to the underweight asset classes.

If you decide it is time to rebalance your portfolio, it is important to assess the tax implications.  Whenever you sell a stock or a bond for a gain outside of a sheltered (retirement) account you must pay taxes.  That said, these taxes can be offset using losses accumulated from the sale of other stocks and bonds that performed poorly through a valuable tool known as tax-loss harvesting.

How Do You Rebalance Your Portfolio?

The actual act of rebalancing a portfolio is simple – if your portfolio is too heavily weighted on bonds, buy stock, and vice versa.  If your portfolio is illiquid, you might have to sell a portion of the over-weighted asset class in order to finance your rebalancing act. The resulting fees are one of the reasons why the gradual approach is much better for preserving capital.

When deciding which investments to buy or sell for your portfolio, don’t forget to look at the correlation between your new assets and your existing portfolio. If your equity portfolio is made up technology companies like Apple or Samsung, consider purchasing shares from another sector such as healthcare, energy or mining.  If your bond portfolio is based around US Treasuries and Blue Chips, think about an emerging markets bond fund to change it up. This is because companies the same industry typically have positively correlated stocks, meaning that they rise and fall together. Uncorrelated assets will help diversify your portfolio and safeguard your capital against market volatility.

Example of Portfolio Rebalancing by Mark Bayley

Consider the portfolio below valued at $10,000. This asset allocation is appropriate based on my own risk-return profile and fees and taxes are not included in this example (but are very important!).

Rebalancing Your Portfolio Indicator

As time passes, equities outperform bonds with a return of 17% compared to a loss on bonds of 8%.  This results in the new allocation seen below. A new portfolio value of $10,990 and an overall return of 9.9%.

It is appropriate to begin rebalancing this portfolio because it has become riskier due to the heavier weighting on equities.  Based on my preferred allocation, I have decided to rebalance my portfolio. To begin, I sell a small portion of my equities and use the increased liquidity to purchase more bonds and keep an additional amount in cash.  This brings my portfolio allocation back to my optimal risk-return strategy.

Over the next year, the market takes a downturn and the equities portion of my portfolio lose 16% while the bonds increase by 10%.

As you can see, the return in the rebalanced scenario is higher than if no action had been taken.  Conversely, if the market had continued to perform as well as it had before my portfolio was rebalanced, I would have earned a smaller return than if I had simply left my portfolio alone.  The difference is that my original portfolio allocation represents my personal target risk-reward profile.

The Takeaway

Bottom line, rebalancing your portfolio is an important part of keeping on pace with your financial goals. Keep in mind that as you grow older, your ability and comfort taking risk might change; people closer to retirement tend to have fewer years of human capital left and thus generally tolerate lower levels of risk than young people, so your strategy will need to be adjusted as time goes on. By acknowledging the personal factors that influence your investing decisions, you can rebalance your portfolio with an allocation strategy that is best suited to your financial needs.

Note: this blog post has been adapted from a prior Voleo post written by Mark Bayley. Want to read the original post? Click here.


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