Should I Rebalance My Portfolio?

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Unless you're a day trader, you shouldn't micromanage your investments or even check them on a daily basis. But on the flip side, investing is not a hands-off endeavor, either.

Investing is about more than just selecting some individual stocks, mutual funds or ETFs and letting them ride. One important aspect for most investors is selecting an asset allocation and periodically rebalancing back to that allocation.

What Is Asset Allocation Rebalancing?

Asset allocation is the percentage of your portfolio allocated to various types of investments or asset classes. Broad asset classes include stocks, bonds and cash. Sub-asset classes include things like small cap stocks, foreign bonds and a whole multitude of investment types and classifications.

Let's look at a simple example of an asset allocation model based on a $100,000 investment.

Our investor uses three Vanguard mutual funds and is looking for a 65% allocation to stocks and 35% to bonds. The initial portfolio looks like this:

Vanguard Total Stock Market (VTSAX) 45%
Vanguard Total International Stock (VTIAX) 20%
Vanguard Total Bond Market (VBTLX) 35%

After a significant runup in the stock market, the allocation might look like this:

Vanguard Total Stock Market (VTSAX) 57%
Vanguard Total International Stock (VTIAX) 28%
Vanguard Total Bond Market (VBTLX) 15%

This could expose the investor to significantly more downside risk than the original allocation.

In order to bring the portfolio back in line with the target allocation, he will want to rebalance it back to the original target allocation.

Benefits of Rebalancing

Rebalancing offers several benefits for investors:

• The process of reviewing your portfolio and accounts on a periodic basis instills a form of discipline on investors. You may or may not need to do any rebalancing at that time, but reviewing your portfolio periodically is a good exercise.
• Rebalancing is a way to control portfolio risk.
• Rebalancing can help you keep your portfolio on track with your overall financial plan.

If you need help figuring out how to rebalance your portfolio, you can use a service like Personal CapitalRebalancing Alternatives

The most common way to rebalance is to sell holdings in asset classes that are over-allocated and then use the proceeds to beef up your allocation in asset classes where you are currently under-allocated.

Be careful, though. Depending upon the types of investments used, this can trigger transaction costs for buying and selling.

Additionally, for money held in a taxable account, these transactions could trigger capital gains or cause you to realize capital losses. This is not a reason to avoid rebalancing, but you should be aware of the tax implications. There may be other ways to do some or all of the needed rebalancing to consider.

Use New Money As Part of Your Rebalancing Strategy

If you contribute regularly to a 401(k) or other workplace retirement plan, adjust your contributions to direct them to asset classes where you are under-allocated. (Investor Junkie has reviewed a service, called Blooom, that was created to help with this.)

Likewise, if you are contributing to an IRA or to a taxable account, direct those dollars to these asset classes.

This might not solve the entire problem, but it can help get your portfolio back in line.

Rebalance Within Tax-Deferred Accounts

Trades made within tax-deferred accounts such as a 401(k) or IRA will not be subject to any tax consequences. Therefore, you don't have to stress out about the potential for any capital gains tax.

Offset Capital Gains and Losses

For taxable accounts, it's important that you understand where all of your holdings stand in terms of unrealized capital gains and losses. If you need to realize a gain on the sale of a holding, try to sell holdings where the capital gains would be considered long term. This means that the fund, ETF, etc., has been held for at least a year and a day. Long-term capital gains are taxed at a preferential rate. This rate may be lower than your marginal tax bracket for ordinary income.

Wherever possible, try to use any holdings where you would realize a loss to offset any potential capital gains. This can take the sting out of rebalancing. Remember, these losses can also be used to offset capital gains arising from mutual fund or ETF distributions. Losses in excess of any gains can be used to offset other income up to an annual limit of $3,000. Unused losses can be carried forward to subsequent tax years.

Automatic Rebalancing

Automatic rebalancing can make this task easier. This feature is offered by many 401(k) plans and other types of workplace retirement plans, as well as many robo advisors. There are even wealth managers that offer the service, like Farther.

In a 401(k) setting, you would generally set a regular interval for your account to be rebalanced back to a set allocation. Annually or semi-annually are usually good choices. You probably don't want to do this with any more frequency than quarterly.

Even if you use automatic rebalancing, you can still go in and make changes manually if needed or desired.

Remember, if you do set this up, it covers only the applicable accounts. You will want to review your overall asset allocation to be sure that your entire portfolio is properly allocated across all accounts.

Have a Plan and Stick to It

During a rising stock market, the temptation might be to let your winners ride. Maybe you will be lucky, and this will work out for you. Or more likely, it won't. You aren't smarter than the stock market. Have a plan and stick to it. Set limits for how far (up or down) your allocations can stray from a target percentage of your portfolio. Review your portfolio at regular intervals and rebalance when needed.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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