I hear it repeatedly from new investors: “I want to get more serious about my investments, but everything I read about investing sounds like a foreign language!”
One of those new vocabulary terms that personal finance nerds like me bandy about is “rebalancing your portfolio.” Like most investing terms, the concept is actually quite simple, and it’s only intimidating when you don’t know what it means.
Here’s everything you need to know about rebalancing, so you’ll never stress about it again.
What Is Rebalancing Your Portfolio?
Some investments perform better over time than others. That means the balance of your investments shifts as time goes by.
For example, say you inherit $100,000 and decide to invest $70,000 in stocks and the other $30,000 in bonds. Fast-forward to a year later: After a good year in the stock market, your stocks have skyrocketed, but your bonds have plodded only slightly higher. What started as a portfolio with 70% stocks, 30% bonds shifted to 80% stocks, 20% bonds. Investors refer to this as “portfolio drift” — another investing term you can throw around at cocktail parties to show off your sophistication.
Rebalancing simply means returning your portfolio to your desired investment ratios. In the language of investing, this target balance of different investments is called asset allocation.
In the example above, the target asset allocation was 70% stocks, 30% bonds. But the stock portion grew faster than the bond portion, so the portfolio drifted to 80% stocks, 20% bonds. To rebalance your portfolio, you sell off some of your stocks and invest that money in bonds to return the portfolio to your desired asset allocation of 70% stocks, 30% bonds.
Within each asset class, investors can — and should — have more detailed asset allocations. For example, among my own stocks, I aim for roughly 50% U.S. stocks and 50% international stocks. You can go even deeper with your target asset allocation; for example, for my U.S. stocks, I aim to evenly split my investments between small-, mid-, and large-cap stocks. This a relatively aggressive asset allocation; risk-averse investors should consider putting more of their money in large-cap U.S. stock funds.
There’s nothing magical about an asset allocation of 70% stocks, 30% bonds. As an investor in my late 30s, I don’t personally invest in bonds at all.
Conventional retirement planning wisdom suggests that the closer you get to retirement, the more you should shift away from stocks and into more stable investments. Stocks offer higher returns in the long term, but in the short term, they can be extremely volatile. For retirees, a crash early in their retirement can be devastating to their portfolio, thanks to something known as sequence of returns risk.
Years ago, the rule of thumb for asset allocation in stocks was 100% minus your age. Thus, a 60-year-old would aim for an asset allocation of 40% stocks, 60% bonds or some other relatively stable asset. But with Americans living longer, many investment advisors recommend shifting that rule to 110% or 120% minus your age, as CNN Money notes. If you use 120% as your benchmark, then a 50-year-old should aim for an asset allocation of 70% stocks, 30% other assets.
But your target asset allocation is a personal decision, based not only on your age but also on your risk tolerance and interests. I have experience in real estate, so I invest a significant portion of my income there, along with stocks.
Whatever numbers you choose, over time, your target asset allocations will shift. Your goal in rebalancing is to keep your portfolio aligned with your target asset allocation, even as it changes with time.
Advantages of Rebalancing
You should rebalance your portfolio as you adjust your target asset allocation with age, but that’s not the only reason to periodically rebalance.
Portfolio drift often causes your asset allocation to shift far away from your target. You might think: Why not let the winners keep on rolling and ride that gravy train indefinitely? However, nothing keeps winning forever. Here’s how rebalancing can help your portfolio.
1. Higher Returns
One advantage of rebalancing is that it forces you to sell high and buy low. Let’s return to the example of a target asset allocation of 70% stocks, 30% bonds and imagine that bonds have a good year, while stocks have a bad year. Because bonds now take on an outsized role in your asset allocation, you sell some of your bonds at a premium since they’re performing well. With the proceeds, you buy stocks to rebalance your portfolio.
Because stocks have performed badly that year, they’re priced low, so you buy at bargain prices. Everyone else is screaming that the sky is falling and stocks are a bad investment, but because you’re investing mathematically and not emotionally, you buy low and are positioned well for the inevitable recovery.
Speaking of investing mathematically, financial advisor Allan Roth demonstrates on ETF.com that, regardless of the target asset allocation, regular rebalancing for U.S. stocks and bonds yielded improved returns for the first 18 years of the 21st century. In some cases, returns improved by as much as 18%. It’s worth noting that a 2017 joint survey between Gallup and Wells Fargo found that the majority of investors who employed financial advisors rebalanced their portfolio at least once a year, compared to only a third of investors who managed their money with no professional help.
As a final thought, bear in mind that not all financial advisors agree that rebalancing improves returns. For example, a study by brokerage firm Vanguard found that rebalancing can sometimes lead to lower returns — but it also significantly lowered the risk of losses.
2. Lower Risk
In bull markets, stocks tend to outperform bonds dramatically. But that can leave investors overexposed to volatile stocks. From mid-2015 to mid-2018, for example, the S&P grew by around 50%. It then tumbled by nearly 15% from September 2018 through December 2018.
An ignored portfolio often sees stocks’ allocation bloat up, leaving the investor vulnerable to a market crash. And while a 25-year-old can weather that crash, a 70-year-old may not be able to afford that kind of volatility. The Vanguard study found that rebalancing annually dropped portfolio volatility from 13.2% to 9.9%, making for a considerably more stable portfolio.
Downsides of Rebalancing
As mentioned above, some advisors contend that the best reason to rebalance is to reduce risk and that rebalancing doesn’t necessarily improve returns. In fact, too-frequent rebalancing can actually reduce your returns.
Here’s why rebalancing can cost you, even while it helps to reduce volatility.
Every time you buy or sell or a stock, mutual fund, ETF, or do any other type of equity trade, you have to pay your broker a commission. (This is why it’s so hard to make a profit on day trading.) These commissions can add up quickly. Each time you rebalance your portfolio, you incur commissions, which eats into your profits.
2. Entry & Exit Load Fees
Some mutual funds charge entry and exit load fees, a cost over and above the commission you pay your securities broker. As the names suggest, an entry load is a fee to buy into a mutual fund, and an exit load is a fee to sell it.
For example, if you own $10,000 of a mutual fund and the exit load is 2%, it would cost you $200 to sell. Double-check these fees before you invest.
Outside of accounts like Roth IRAs and 401(k)s, where your money grows tax-free, you must pay taxes when you realize gains by selling investments.
If you’ve owned the investment for over a year, prepare to pay capital gains taxes on your earnings. For investments you’ve owned for under a year, brace yourself to pay the full income tax rate. This is yet another reason not to rush into selling investments too frequently.
Conventional wisdom used to hold that you should rebalance at least once a year, but that’s not much of an answer. To more accurately — and more profitably — answer the question, here are several common approaches to rebalancing.
1. Periodic Rebalancing
The problem with rebalancing too frequently is that, as outlined above, there are costs and taxes involved. And if your portfolio hasn’t shifted much — let’s say it’s drifted from 70% stocks to 71% stocks — it’s not really worth incurring those commissions and taxes.
As the name suggests, periodic rebalancing involves rebalancing your portfolio on a regular schedule, such as quarterly, semi-annually, or annually.
2. Tolerance Band/Threshold Rebalancing
An alternative to rebalancing your portfolio every few months or every year, whether it needs it not, is “tolerance band” or “threshold” rebalancing. Under this strategy, you rebalance your portfolio whenever it drifts beyond a certain threshold in either direction.
For example, say you set a threshold of 5%, and your target asset allocation is 70% stocks, 30% bonds. When your portfolio drifts to 75% or 65% stocks, you then rebalance, whether your last rebalance was three weeks or three years ago. This way, your portfolio never drifts too far from your target asset allocation.
But this raises another problem: What if the market undergoes particularly violent swings and triggers a rapid succession of trades? If the market fluctuates too much, you may find your portfolio constantly incurring commissions and triggering taxes.
Unless you automate your rebalancing, this also becomes a labor-intensive exercise. Checking your portfolio every day is a recipe for lost time and sanity.
3. Combined Threshold & Periodic Rebalancing
Want the best of both worlds? You can have it.
In combined threshold and periodic rebalancing, you review your portfolio on a regular interval, but you only bother to rebalance if it’s drifted beyond your predetermined threshold. For example, you check your portfolio annually but only rebalance it if the asset allocation has drifted more than 5%.
This approach helps you minimize your rebalancing effort and costs by only rebalancing infrequently and when your portfolio really needs it.
4. Cash Flow Rebalancing
Another option is cash flow rebalancing. Instead of selling high-performers — and incurring commissions, taxes, and possibly exit loads — this option involves only buying.
As your portfolio drifts, you can practice cash flow rebalancing by only buying assets that are underrepresented at that moment. For example, say you invest $1,000 every month, dollar-cost averaging as a tactic to reduce risk. When you log into your brokerage account to invest, you notice that your asset allocation has drifted from your target of 70/30 to 75/25. So instead of investing any of this month’s $1,000 in stocks, you invest it all in bonds and keep doing so until your asset allocation is back to your target of 70/30.
This also works with your dividends. Instead of automatically reinvesting dividends, you can invest them manually whenever your portfolio needs a nudge.
Cash flow rebalancing is particularly effective for adults in their 20s, 30s, and 40s who regularly invest money but are not yet withdrawing money or nearing retirement.
5. Rebalancing Stocks Alone
The trouble with rebalancing from stocks to bonds is that bonds tend to offer lower returns over time. When your stocks perform well, and you keep pulling money out of them and shoveling it into bonds, it boosts the odds that your rebalancing will reduce your returns rather than improve them.
But certified financial planner and writer Michael Kitces demonstrates that rebalancing your stock portfolio alone generally leads to higher returns. That’s because across regions and market caps, some funds underperform and others outperform, so as long as they have a similar long-term expected return, rebalancing helps you capitalize on selling high when one segment outperforms and buying low when another segment underperforms.
As touched on above, my target stock allocation by region is 50% U.S. stocks, 50% international stocks. Within each of those regions, I aim to split these stocks into thirds for even exposure to small-, mid-, and large-cap index funds. Thus, when U.S. stocks do well but international funds stumble, I end up selling U.S. funds while they’re high and buying international funds when they’re low, and vice versa. Likewise, when small-cap funds outperform large-cap funds, rebalancing forces me to sell the small-cap funds while they’re high and invest in large-cap funds that are underperforming.
6. Automated Rebalancing
According to the Gallup-Wells Fargo survey above, 31% of respondents said they would rather be stuck in traffic for an hour than rebalance their portfolio.
I get it. Picking over your portfolio and manually analyzing, selling, and buying is hard work. And, let’s be honest, when the market is tumbling, the last place many investors want to look is their shrinking investment portfolio.
Fortunately, the last 10 years have given rise to so-called robo-advisors, which can automate your investments and portfolio management. When you create an account with an automated investment advisory service like Betterment or Personal Capital, you select your target asset allocation, target retirement date, and other personal preferences, and the robo-advisor handles it all for you. No muss, no fuss; it all happens in the background automatically.
The closer you get to retirement, the more attention you should pay to asset allocation and rebalancing.
In your younger years, rebalancing is largely an exercise within your stock portfolio to help you boost returns. As you get older, and gradually bonds and other low-volatility investments assume a larger role in your portfolio, rebalancing shifts to become a risk-reducing strategy.
If you’re younger, and you invest a certain amount every month, try cash flow rebalancing. It lets you rebalance every month, without having to sell and incur commissions and taxes, and without having to watch your investments like a hawk.
Investors nearing or in retirement should consider combined periodic and threshold rebalancing to keep their portfolio on target and relatively safe. Put a recurring alert on your calendar for the same day every year, reminding you to log into your brokerage account and check your portfolio drift. If it’s more than 5% or 10% away from your target, rebalance it. If not, don’t sweat it.
Do you regularly rebalance your portfolio? How do you approach it?