When you rebalance your portfolio, you’re reestablishing your target mix of asset classes on a regular basis. And when you don’t rebalance, it’s akin to letting the market decide your asset allocation. Over time, that can change your exposure to risk.
Let’s consider Matt and Jessica, a hypothetical couple who started out with a $300,000 portfolio in 2010. Their original allocation of 60% stocks and 40% bonds has delivered hefty gains since they set it five years ago, when the stock market started to rebound, and their portfolio has now grown to $524,300, not taking into account fees and expenses.
But different asset classes can grow at different rates, as the chart below shows, and now the equity part of their portfolio is weighing in at about 71% of their allocation, and bonds a mere 29% (a roughly 70/30 split).
To rebalance, Matt and Jessica would need to sell some of the assets that have appreciated the most—stocks, at the moment—and buy bonds. But with the S&P 500® index up nearly two and half times over the market low of March 2009, they’re tempted to let the good times roll on (and let their portfolio be).
At this point, they might remind themselves that rebalancing is about more than just managing your exposure to certain asset classes—it’s about managing your exposure to risk. In this case, if the couple had rebalanced back to their 60/40 allocation every year, they would have roughly the same amount—$516,800 vs. $524,300—but without the added risks that the more aggressive 70/30 allocation could bring.
Additional benefits of rebalancing
That’s not to say that rebalancing is a magic bullet. But to help maintain their target allocation and reduce unwanted risk exposure, it would be wise for Matt and Jessica to rebalance in a disciplined way—to manage their portfolio based on their risk tolerance, not market performance, says Rob Williams, managing director of income planning at the Schwab Center for Financial Research.
Granted, it can take nerves of steel to prune back a rising asset and buy more of one that’s fallen in value, but a more useful perspective is that you’re reestablishing the optimal level of risk for your plan. Also, by rebalancing, you:
- Harvest your gains in a methodical way
- Manage your portfolio’s risk to stay in line with your objectives and risk tolerance
“Rebalancing helps you to do what you know you should do—but might not do without a plan: Buy low and sell high, in a disciplined fashion over time,” Rob says.
Instilling the discipline of rebalancing
Sometimes it helps to have a few guidelines (or tools) to help you stick to your plan.
First, review your asset allocation annually to make sure it’s appropriate for your goals and time horizon. This questionnaire can help you assess your portfolio in light of your current situation.
Next, write down your general investment goals and strategy, and then stick to them. This will help you protect yourself from panicked—or overly lax—reactions to bad markets or news. Behavioral finance research shows our brains are hardwired to feel a loss more acutely than a gain, which can tempt you to bail out of a falling market, Rob cautions.
Include rebalancing as part of your plan, and specify ranges for your allocation to each asset class. An example: “My goal is to be within X allocation, and if I get 5% out of whack, I’ll implement my rebalancing strategy.”
And last, check the tax ramifications before you buy and sell. In tax-deferred plans, such as IRAs and 401(k)s, there are no tax consequences for making changes to your allocations. But you may owe tax on realized gains (not to mention transaction costs) within your taxable brokerage account, so be judicious about how often, and what investments, you sell to rebalance. One way to avoid triggering taxes in taxable accounts: Use new savings to buy asset classes in which you’re underweight, instead of selling existing securities to rebalance.
You don’t have to go it alone
As a way to manage risk and prevent portfolio drift, rebalancing makes sense. But it can be hard tactically as well as emotionally to follow through and execute, especially when your assets are in several accounts. If you prefer not to manage rebalancing on your own, there are other options: