If you have invested in a diverse mix of securities, you are likely to find at the end of the year that your portfolio’s asset class weighting has changed. This is to be expected, since your assets will have changed in their market value over time. To correct for this change in relative weight among your investments, you can rebalance your portfolio. Here’s what you need to know about how and when to rebalance your portfolio.
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What is Portfolio Rebalancing?
Most investment strategies involve holding a diverse array of assets, like stocks, mutual funds, bonds, and ETFs, typically in a predetermined ratio. This ratio varies based on many factors including an investor’s age, financial status, and risk profile.
Over time, the change in market value for each asset you hold can change the weight or ratio of each asset class in your portfolio. Rebalancing can help realign your portfolio with your preferred asset allocation ratio by strategically selling and buying assets.
It should be noted that rebalancing is neither necessary nor necessarily beneficial for every investor. Rebalancing is a tool that investors can use to help fix a perceived problem in their investment profile.
It is important to understand that rebalancing your portfolio should not be viewed as a tool for maximizing returns. Instead, rebalancing is a tool you can use to help manage your risk. For instance, if you are a risk averse investor and your higher-risk investments generate large returns, more of your money will be placed in riskier investments than you originally contemplated—so rebalancing might be warranted to redistribute your money into less risky assets.
When to Rebalance?
Many individuals decide to rebalance at regular intervals while others almost never rebalance their portfolio. Still others choose to rebalance after a certain condition has been met, such as a 5% rebalancing threshold.
As an example, suppose you have a split of 60/40 between stocks and bonds, with a total $50,000 invested—so $30,000 in stocks and $20,000 in bonds. At the end of the year, suppose that your stock’s value has grown by 33%, adding $10,000 to your portfolio, while your bonds have gained five percent in value, adding $1,000 to your portfolio. Your original portfolio allocated 60% of your $50,000 in stocks and 40% in bonds, but now your portfolio allocates about 65.5% of your $61,000 in stocks and 34.4% in bonds.
Your ratio has changed by more than 5%, placing more value in your stock investments and less value in your bonds than you had originally planned. For many people, a change of more than 5% in an asset is considered a reason to rebalance their portfolio.
How Often Should You Rebalance?
As stated above, individual investors decide to rebalance their portfolios at different times and for different reasons. As in our example, many investors consider a change in 5% of a single asset to be a sign that they should rebalance their portfolio.
Other individuals rebalance their portfolio yearly, typically around either when they are preparing their tax filings near April or taking advantage of tax-loss harvesting around December. Some choose to rebalance monthly or quarterly, while some never rebalance, instead letting the market decide.
How to Rebalance Your Portfolio
There is no set process for rebalancing. However, one general idea is to sell some of your investments in the asset class you want to reduce and buy investments for the asset class you want to increase.
In other words, you can rebalance by buying more of your lower-performing investments and selling some of your higher-performing investments. Another method for rebalancing is to invest new money in a way that restores your portfolio’s preferred ratio.
These two main strategies, reallocation or additional investing, can be executed in various ways. For individuals with multiple investment accounts, some choose to rebalance each account individually while others choose to rebalance by treating them as a single large portfolio. Some will rebalance every time they make contributions into their accounts or withdraw funds.
In the example above, for instance, to return to your desired 60/40 split you may want to sell some of your stock investments and buy more bonds until you have $36,600 invested in stocks and $24,400 in bonds.
Should I Rebalance?
As we have explained here, rebalancing can mean different things for different people. Additionally, rebalancing is primarily about reallocating your risk and not about increasing your returns. As a result, the answer to the question, “Should I rebalance?” will be different for each investor based on their investment choices and their risk profile. Ultimately, as an investor you have the power to determine if and when rebalancing is right for you.
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The experienced financial advisors at The Templeton Group of Cornerstone Financial Management can help you build an investment strategy that aligns with your goals and risk preferences. Get in touch today to request a consultation.