You may have heard friends or financial advisors mention their rebalanced portfolio and wondered "what is portfolio rebalancing?" or "how does it work?". In this guide we will seek to provide easy to follow education on what portfolio rebalancing is, so that you may rebalance your portfolio by the end of this article.
Portfolio rebalancing is performing the necessary trades in your investment portfolio back to the desired asset allocation. This means you sell overweight stocks or asset classes and put the proceeds into an underweighted security or asset class.
The most common reason to rebalance is to account for eventual portfolio drift that occurs when you aren't a day trader constantly adjusting your asset mix and actively managing your investments.
At Peak Financial Planning we seek to educate investors, specifically those within the Retirement Risk Zone. We define the Retirement Risk Zone as the 10 years on either side of your retirement. This is when your portfolio can have a dramatic effect on your retirement success.
Let's consider a hypothetical scenario that we have seen before:
For example, your target asset allocation is 60% stock and 40% bonds. At the time of writing, the stock market has had record performance, which may turn your portfolio value into 80% stocks and 20% bonds. The balance among asset classes is askew.
In order to rebalance your portfolio, you would sell that extra 20% of your account value that is held in stocks. Once the proceeds have settled, you can reinvest that cash in the other asset classes that have lowered in your portfolio weight, in this case bonds. This gets you back to the original allocation, hence rebalancing.
This is not to be confused with tactical asset allocation which involves changing your short-term investment strategy to accommodate your personal finance needs or attempting to capitalize on market fluctuations.
Tactical asset allocation means that you change your targeted allocation weights to serve a temporary purpose. Rebalancing is changing your current asset allocation back to the desired allocation set out in your investment strategy.
Think of clearing a messy canvas as opposed to getting a brand new one, or trying to get back to your normal goal weight after a vacation versus moving your goal weight because you have new desires based on new health goals.
The typical financial advisor leaves you with many unanswered questions. We have spoken with many people who have felt disgruntled and ignored by large financial services companies. Often advisors create a tangled web of obscure promises that leads to a lack of clear, decisive, and accountable actions.
There are many moving parts to rebalancing strategy which must be accounted for when you actually rebalance your portfolio. Should you follow the same path as everyone else, you can't expect to have exceptional results that beat the average performance.
Here are a few shortcomings with traditional rebalancing strategy:
Asset allocation is not the only consideration with portfolio risk. We believe that the concept of asset allocation oversimplifies investing and inhibits the creation of ideal retirement circumstances. Oftentimes investors believe that a 3 fund or 5 fund portfolio is the best they can do.
That 3 or 5 fund portfolio's asset mix is usually a blend of mutual funds or ETFs (exchange traded funds) consisting of domestic stock, emerging market stocks, an aggregate bond index, and international stocks.
Using a standard asset allocation is better than not investing at all. However, it doesn't account for all market conditions and your nuanced individual needs.
Beyond a mix of specified weights on each asset class, popular rebalancing strategies often ignore the qualitative factors that make you who you are.
Individual risk tolerance needs to be considered. A standardized asset mix can't possibly accommodate what you need and your financial goals. Having a one size fits all strategy means that as market performance or your goals change, you're stuck with the original asset allocation and all of its inherent risk.
This is why you need a custom investment strategy that is tailored to your needs and goals. We account for your personal life with regards to your investment goals. If going to a financial consultant, seek a fiduciary that has legal obligation to put your interests first. Peak Financial Planning is a team of fee only fiduciary financial advisors who care about your retirement success.
Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
Many proponents of steadfast asset allocation are too scared to alter their asset mix, and only go back and forth between their original asset allocation and whatever the portfolio value currently sits at.
This isn't a terrible strategy that is useless in entirety. But it doesn't give you flexibility to adjust your investing goals based on the new factors of your life. Things remain rigid and locked into the asset classes that you originally picked out. You may have 50% domestic stocks, 20% stock in emerging markets, and 30% of bond allocation. Should staggering bear markets come along and diminish all three portions of your asset allocation, you have nowhere to go.
This leads us to tell you don't be afraid of selling assets entirely. You are allowed to change your investment selection or adjust your target asset allocation. Keeping your portfolio consistent in each position for your investing tenure no matter the circumstances does not serve your best interest.
Your current portfolio may not be your best option when your financial goals change during declining markets. Especially during the Retirement Risk Zone because you are exceptionally vulnerable to factors like sequence of return risk.
Your portfolio's allocation may shift with your life changes or market fluctuations, which can be called rebalancing events. These are times where prudent investors will reevaluate their asset allocation and financial goals.
Rebalancing is better than doing nothing with your portfolio for your entire investment duration. Not rebalancing lets the market dictate risk because you will be stuck following the market wherever it goes, with no room for course correction.
That being said, there is no perfect answer to the question of how often should you rebalance. The goal is to pick a well balanced approach that is proactive, rather than reactive. Picking any period of time as a hard rule isn't always the best option. Using a set time horizon to always evaluate has its pros and cons.
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Here we will walk you through the two most common rebalancing strategies. You can think of those two as target allocation bands, or periodic/ calendar rebalancing.
One of the most popular rebalancing strategies is to use weighted tolerance bands. This involves attaching limits to keep the portfolio close to the desired asset allocation in terms of worth as portfolio weights.
A more detailed explanation is to set guard rails for each position you hold in your investment portfolio based on the target allocation percentage of your portfolio's value. For example, you invest in ten ETF's that all constitute 10% of your portfolio as a whole. They might all constitute individual sectors of the market, or different asset classes. The dollar value of each will change as the market fluctuates, but your target allocation is 10% in each fund.
If one of those ten funds inflates in value to the point that they end up being worth 20% of your total portfolio value, then you would need to rebalance your portfolio to stick to the asset allocation goal of each fund being worth 10%.
You can think of rebalancing your portfolio as selling off overweight stocks and reentering another underweighted asset class. This may be lowering the amount of money in stock investments and increasing the amount of money in bond investments.
Another factor of avoiding excessive trades is minimizing transaction costs and high taxation. Depending on your rebalancing strategy transaction costs can take up much more of your proceeds than expected.
A common question is how often should you rebalance your portfolio?
There is no definitive answer for every investor. The other side of the rebalancing token besides tolerance bands is balancing by period. You can think of this as picking a time frame which will automatically be part of your rebalancing events.
Another important factor to consider when using tolerance bands is the tax implications of trading positions. If you are using taxable accounts, each sale can incur tax liability, even if you don't have capital gains. If you are in a high-income tax bracket you will want to minimize taxes from your investments which means even less frequent trading.
Frequently rebalancing means more transaction fees because you will be trading more often. Of course, you want to manage risk, but you will need to find a balance between micromanaging your portfolio and being completely hands off.
Annual rebalancing means adjusting your asset class and portfolio weights at the start or end of every year. Most people use this as an opportunity for going back to the original asset allocation once a year.
Quarterly rebalancing would be rebalancing every 3 months, which tracks more closely to a tactical asset allocation strategy.
Rebalancing once per quarter is a balance of "tactical and strategic investing" using traditional terms.
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At Peak Financial Planning we believe that a hybrid of both periodic and bands strategies give the best outcome to investors when utilized together.
There is a very fine line between overly frequent rebalancing and minimizing portfolio drifts. While you don't want to stray too far from your target asset allocation, you also don't want to be neurotic about your investments.
We use quarterly rebalancing as a guard rail, while actively checking for important life changes or economic events. We account for personal risk tolerance with regards to dynamic life events. Should an investor be approaching retirement, we may downshift their risk levels depending on required portfolio income and Social Security claiming age.
Each person has differing circumstances, but we also assign tolerance bands to keep things close to the target allocation.
This allows us to achieve the best mix of letting winners ride within a certain specified tolerance to allow for capital gains, while maintaining the flexibility for strategies such as tax loss harvesting.
Portfolio rebalancing helps facilitate risk management with your investment goals. This takes shape in the reduction of more aggressive investments to recreate a more balanced portfolio, usually a reduction of your equity portion from investments like international stocks.
When you rebalance your portfolio, you also gain additional help in reducing emotional impact on your investment portfolio in order to safely manage risk.
Many investors often get ensnared in the trap of impulsive and emotional decision making. This comes from a place of fear rather than education. Using a systematic rebalancing strategy can help regulate emotions and remind us that there is a goal in sight.
Nobody likes to see down positions in their portfolio. That being said, rebalancing helps losing positions turn into opportunities. Tax loss harvesting is an example of this for anyone who has locked in capital gains.
With regards to tax loss harvesting and active maintenance, we like to remind investors to be proactive in trimming losers. Bear markets don't have to be entirely bad because they can help you safely extract tax free gains that were previously locked in.
Our objective is to teach those who seek help investing for retirement success.
Rebalancing your portfolio doesn't have to be complicated. Your target allocation is a guideline not a hard rule. Do not be constricted by past performance or asset class percentages. Having 50% in the S&P 500, 10% in emerging market stocks and 40% in bonds is not a full proof strategy.
When you rebalance your portfolio you can use a simple checklist that follows a similar structure each time:
When you decide to rebalance or change your portfolio, you MUST remember, historical data is a guideline not a rule. Previous performance does help guide decisions, but you should never follow it as a guarantee of what to expect in the future.
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You need to consider the tax effects of your investment decisions, especially if you are in retirement, as taxes will be one of your biggest expenses. One of the biggest factors in your tax planning is the type of account you are managing. A taxable account will incur tax liability when selling for a gain, but IRA's and tax deferred accounts will not incur tax until you withdraw funds.
Because taxable accounts will create tax consequence after sales, you are somewhat limited to the frequency with which you can rebalance them. Overly frequent rebalancing in a taxable account can lead to a severely inflated tax bill. That being said there are steps you can take to mitigate your tax liability.
You can use tax loss harvesting as an opportunity or vehicle to rebalance your portfolio. Tax loss harvesting is when you sell positions that have unrealized losses, to balance out gains you've taken from your taxable account. This is a strategy that helps you extract gains from your portfolio without having to pay income tax. There are rules you have to account for however, such as long term losses must first be used against long term gains.
While you should be aware of your tax situation, don't avoid rebalancing entirely in taxable accounts. If you never rebalance your portfolio, you will end up with locked in gains that you may not be ready to extract, which end up ruining diversification opportunities and making it difficult to navigate in the future.
There are multiple things you need to be aware of should you manage your own investments. This is a difficult endeavor that should not be taken lightly. Investment management takes years of practice and research to become skilled. Here is a breakdown of factors that don't get as much spotlight as they should when discussing investing.
You will need to accommodate transaction costs and looming tax bills when creating your rebalancing strategy. Each transaction may create tax liability or fees with the company that is holding your investments.
Individual asset class can also be a factor here. With funds, you must consider the class you are investing in. Class A funds will charge you an entry fee, class B funds will charge you a declining fee to exit your position, and class C will have both types of fees. Some stock investments are made to have low expenses, with much higher risk. Each type of bond can have different tax liability for interest and principal.
Make sure to thoroughly research your asset choices and how they fit into your personal situation. Remember that a blanket strategy can't possibly be the best choice for everyone who uses it.
Many investors forget that a sale must be followed by a purchase unless you are planning to withdraw that cash soon. The only other time to wait on reinvestment is in anticipation of a drop in your chosen investment or asset class.
You will need to reinvest the newfound cash from any sale, or deposits of cash from an external account, to keep up with your investing goals. Otherwise, that cash will be eroded by inflation and racking up opportunity cost.
The cost of rebalancing your portfolio will depend on which sales you make, market timing, and your investment goals. Selling positions can create fees or tax liability. The time you rebalance is important because it may change the asset class weights you shift to. Your personal goals will change what strategy you take and what you invest in.
There is no set answer for the cost of rebalancing a portfolio but you can choose when to rebalance based on your individual situation. The costs you face are your tax liability, opportunity cost, and whether or not you are closer to your goals.
What matters most is that you evaluate your cost and performance based upon your own needs. Every investor has a unique baseline and goals that shift with THEIR lives.
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The pros of rebalancing are managing your risk, having a strategy to help you decide when or how to take profits or losses, and stability in terms of emotional decisions. Shifting portfolio weightings helps lower risk in overconcentration of one asset. The ease of a rebalancing strategy can allow you to help make decisions with regard to timing, attachment to assets, or asset weighting.
The cons are potential taxes, automatic rebalancing when you aren't prepared, and the responsibilities that follow a rebalance. Sales should be made with consideration to future tax consequence. You also need to be aware of automatic trades should your rebalancing happen without manual approval. Research should also be done into what you invest in, and how to invest cash from sales made.
Rebalancing can affect returns, just like any investment decision. You can't predict future performance with 100% certainty, but you can prepare and make educated decisions. Rebalancing will ideally raise your returns by shifting into assets that will perform well.
Rebalancing strategies are beneficial for investors that don't plan to buy and hold an investment. Rebalancing will help anyone manage a portfolio whether it be performance or decision making. Whether or not you adapt your strategy may further affect performance but having a strategy in the first place helps establish guardrails to manage your investments.
Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
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