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Portfolio Repair: A Case for Rebalancing

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).

Chart: Without rebalancing, this allocation became more risky

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:

  • If you work with a financial advisor, ask if rebalancing is included as part of their services. 
  • Many of Schwab’s Portfolio Management Services include options for rebalancing. 
  • Schwab Intelligent PortfoliosTM, offered by Schwab Wealth Investment Advisory, Inc., also offers automatic rebalancing.
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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

Investing involves risk including loss of principal.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. The performance results do not represent the results of actual trading. They are simulated results using what The Schwab Center for Financial Research considers to be representative benchmarks designed with the benefit of hindsight.

Schwab Intelligent Portfolios:

Please read the Schwab Intelligent PortfoliosTM disclosure brochures for important information.

Schwab Intelligent PortfoliosTM is made available through Schwab Wealth Investment Advisory, Inc. (“SWIA”), a registered investment advisor. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. (“CSIA”). SWIA and CSIA are affiliates of Charles Schwab & Co., Inc. (“Schwab”) and subsidiaries of The Charles Schwab Corporation.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Index Definitions:

The S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity and industry group representation.

Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

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