You’re probably aware that investing has no “fire-and-forget” feature. Whatever your portfolio assets mix was a year or two or more ago, it’s probably out-of-date: The financial universe is a dynamic place where constant rebalancing is the order of the day.
While it is important to get started saving for retirement, you also want to make sure you maximize the investment growth of your contributions. How do you manage to have some form of control over your investment allocation short of becoming a trader? The answer, in a word, is rebalancing.
What Is Rebalancing a Portfolio?
Rebalancing is the periodic adjustment of your asset allocations to conform with your predetermined investment goals. When one asset class rises and begins exceeding your desired allocation for that class, you sell off the excess investment and transfer the proceeds to another asset class that’s fallen below the desired level. It’s a way of keeping a consistent allocation without micro-managing your portfolio.
The Mechanics of Rebalancing
The best way to explain how rebalancing works is by example. Let’s say that on January 1st you decide that you want to maintain a certain investment mix for your $100,000 portfolio that you feel will meet your investment goals. Here’s how the process works:
1. You set your desired allocation—we’ll say 50% in stocks, 30% in bonds and 20% in money-market funds.
2. You chose a rebalance point—one year later for our purposes.
3. During the course of the year, stocks rise by 30% and your bond and money markets by just 10% each; you now have $65,000 in stocks, $33,000 in bonds and $22,000 in money markets, for a total of $120,000.
4. Because of the changes in valuations, stocks now comprise about 54% of your portfolio, bonds are at about 27%, and money markets are at about 19%.
5. On the one-year anniversary date, in order to bring your stock position back to 50%, you sell enough stock holdings—$5,000—to bring your stock investments down to $60,000, which is 50% of $120,000.
6. You use the proceeds from the sale of your stocks to increase your bond and money-market positions. Out of the $5,000 you raised from selling stock, you invest $3,000 in bonds, bringing it to $36,000, or 30% of your portfolio. The remaining $2,000 is invested in money-market funds, to bring that position up to $24,000, or 20% of your portfolio. You’re now fully rebalanced back to your original investment allocation of 50% stocks, 30% bonds and 20% money markets.
7. You do the same thing each year thereafter. Reallocation should be set at specific intervals but no less than annually. You should also have the flexibility to make non-scheduled rebalancing in the event that a certain asset class is looking top heavy and ripe for a fall. If the market jumps 25% in a certain area of your portfolio, it might be wise to rebalance early to lock in some of your gains before the next market correction.
Rebalance for Taxes, Too
Rebalancing should be an annual (or semi-annual, for some) activity for every investor. Likewise, rebalancing between your tax-advantaged and non-tax-advantaged accounts is important too, depending on whether you think your tax bracket will increase or decrease when you retire.
Tax rules and legislation could change at any time, and younger investors might live through several changes throughout the decades. Instead of dedicating yourself 100% to one type of account or the other, mix your investments in both tax-deferred and non-tax deferred accounts.
Rebalancing is easy to do in tax-sheltered retirement accounts, which are usually invested in highly liquid mutual funds. You can choose to sell off a portion of a given mutual fund, or to sell off an entire fund. Mutual funds also make it easier to move money between asset classes, and transaction costs are generally lower than with a large number of individual securities. (Check out our articles: Should You Pick Individual Stocks?)
You should also consider rebalancing allocations within asset classes. This is especially important with equities. If you originally allocated 10% of your portfolio to energy stocks, but a run-up in share prices has caused that percentage to increase to 40% of your portfolio, you will be heavily overweight in a single sector, one in which wild swings is hardly unusual.
One way to get around—or at least minimize selling one class and buying others—is by investment contributions. Instead of selling a high-performing class, you can use any new funds you add to your portfolio to increase positions in the underperforming ones. This is especially practical in tax-sheltered retirement accounts where you’re making regular contributions.
How to Rebalance for Taxes
When it comes to tax considerations, the best method of adjusting your mix is based on your age. If you are in your 20s and just starting investing, a 50/50 mix between taxable and tax-deferred accounts might be appropriate. If you are much closer to retirement, you should have a much better feel for where your income will be, and can adjust funding accounts accordingly. Just as your investments should become more conservative and focused on income than capital growth as you grow older, your investment tax mix should hone in on your selected retirement strategy as you age.
Here are two methods to balance your tax mix over two separate accounts (a 401(k) and a Roth IRA):
- If you aren’t yet able to contribute the maximum to either account, simply put less money into the account with the higher balance. Just as you would sell off some stock to lower an allocation, you minimize contributions to that account.
- If you are already contributing the maximum to both accounts, things are more tricky. Let’s say your stock/bond mix needs to be 80%/20%, but has grown to be 85%/15%. One account has grown a bit larger than the other. The following year, you can keep your money flowing into an 80%/20% mix, but you would invest more in bonds in the account that is the largest. Assuming stocks outperform bonds, that account would not grow as fast as the other, which would balance out your mix.
Buy Low, Sell High
One of the benefits of rebalancing is that it enables you to make that hoariest of financial adages a working part of your investment strategy. Since you’re regularly selling the best-performing asset classes in your portfolio, there’s less risk that you’ll be caught with too great a position in a class that’s about to topple. At all times, at least some of your best investment gains will be locked in because you sold them and moved the proceeds into other assets.
Similarly, since you’re regularly buying asset classes that are underperforming, there’s an excellent chance that you’re buying them well off their highs. You’ll be buying those classes when they’re out of favor, and that’s the time to get the best prices.
Rebalancing can keep you on track with your investment goals, with the side benefit of minimizing the emotional factors that often interfere with sound investment decision making. You make your allocation, then rebalance once or twice a year. Investment portfolio strategy reduced to simple math equation—does it get any easier than that?