Whether we are talking about dollar cost averaging, index investing or automating our finances…it’s often the simplest ideas that have the largest impact on building wealth.
Another concept that we can add to that list is portfolio rebalancing.
Today, we will be covering the basics of portfolio rebalancing including:
- What is Portfolio Rebalancing?
- How to Rebalance a Portfolio
- Pros & Cons of Portfolio Rebalancing
What is Portfolio Rebalancing?
Portfolio rebalancing is the process of adjusting the allocation of assets within our investment portfolio to be back in line with our desired target allocation.
As an example, imagine that our preferred risk tolerance calls for a 50/50 portfolio of stocks to bonds. After several great years of stock market returns, our portfolio has shifted to an allocation of 75% stocks to 25% bonds.
The asset allocation of our portfolio is now considered more aggressive. This is a natural part of the portfolio lifecycle because the different assets in our portfolio will grow/shrink at different rates over the years. The result is that our desired asset-allocation tends to drift off course.
And while we may not see any significant changes in the short-term, not rebalancing can have major long-term implications. Therefore, we need to rebalance our portfolio in order to get our asset allocations back in alignment with our preferred risk tolerance.
How to Rebalance a Portfolio
OK – But how would we actually go about rebalancing our portfolio?
Believe it or not, the answer is quite simple. Using our example from earlier, we would just need to sell 25% of our stocks and roll those proceeds into our bonds. Executing these two transactions would get our portfolio back to our desired 50/50 asset allocation.
With that being said, we shouldn’t be rebalancing every day/week. That’s a surefire way to go crazy as well as waste an absurd amount of money in transaction costs/fees.
To be honest, the easiest way to rebalance a portfolio is via “Calendar Rebalancing.”
Here’s how ‘Calendar Rebalancing’ works in a nutshell:
- Choose a frequency that works best for you (i.e., Quarterly, Annually, etc.)
- Calculate your current asset allocation and compare it to your desired asset allocation
- Buy/Sell investments within your portfolio to get back in alignment
It’s that easy 🙂
Pros & Cons of Rebalancing
Portfolio Rebalancing Pros
Risk Management
As we mentioned earlier, the primary benefit of portfolio rebalancing is managing risk.
This is done by preventing our portfolios from becoming overly concentrated in a single asset class that might become more volatile and/or underperform. By rebalancing our portfolio on a regular cadence, we are creating a more stable portfolio over the long-term.
Locking in Gains
Another benefit of portfolio rebalancing is locking in our gains.
Through the process of selling over-performing assets, we can lock in ‘realized gains’ and redistribute them to underperforming assets.
While this may initially seem counter-intuitive, it’s important to remember that we haven’t technically gained anything until we sell. Yes, we made money on paper… However, those gains are not real until the assets have been sold for cash.
Promotes Discipline & Long-Term Thinking
When it comes to investing, we can be our own worst enemies. A common example of this is impulsively reacting to short-term market movements in order to maximize our returns.
However, committing to a 'Calendar Rebalancing' routine, wherein one buys or sells securities only a few times a year, can promote a disciplined and long-term investing strategy.
Portfolio Rebalancing Cons
Tax Consequences
One of the biggest turn offs with portfolio rebalancing is potentially triggering a tax event.
With that being said, it should be noted that any trades done in tax-advantaged accounts (i.e., a HSA, 401(k), Roth IRA) are not taxed.
Additionally, we can also minimize taxes in taxable brokerage accounts by using techniques such as tax-loss harvesting to offset any capital gains that may have occurred when rebalancing.
Psychological Challenges
As previously mentioned, we can be our own worst enemies when it comes to investing.
More specifically, rebalancing may go against our emotional impulses.
An all-too-common example of this is continuing to hold onto high-performing assets, even if they are overweighted in our portfolio.
Although these assets may have performed well in the short term, it's essential to actively rebalance our portfolio to mitigate risk exposure and ensure alignment with our long-term goals.
Final Thoughts
Rebalancing a portfolio is a lot like tuning a musical instrument. It doesn’t take much time, but ends up making a world-of-difference in the quality of the output.
Disclaimer: Nothing in this article should ever be considered advice, research or an invitation to buy or sell securities. I am not a financial advisor.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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