Deciding how to allocate your portfolio across different types of assets is essential to ensuring your investing approach is in line with your goals and risk tolerance. But asset allocation isn’t something you should set and forget.
Over time, market fluctuations and asset appreciation can cause your portfolio to drift from your desired allocation. By rebalancing your portfolio, you can keep your investment allocation aligned with your risk tolerance and better manage your risk over the long term.
Why Your Portfolio Needs Regular Rebalancing
Exactly how does your portfolio become out of alignment with your goals and risk tolerance? The market’s performance in 2021 serves as a great example.
Let’s say you started 2021 with a portfolio of $500,000 invested across stocks and bonds. (For simplicity’s sake, we will refer to individual stocks and stock funds as “stocks” and individual bonds and bond funds as “bonds.”) Let’s assume you have a moderate risk tolerance, so you set your asset allocation at 50 percent stocks and 50 percent bonds.
The S&P 500 rose by an incredible 26.9 percent in 2021, while US bond returns were down 3 percent on average. As a result, your $500,000 portfolio would have been worth $559,750 at year end. That’s quite a nice return for the year! However, thanks to stocks significantly outperforming bonds in 2021, your portfolio allocation at year end would have been 56.7 percent stocks and 43.3 percent bonds—not the 50/50 allocation you originally set up.
Because your investment portfolio can drift from your intended asset allocation over time, it’s important to rebalance your portfolio periodically.
How Advisors Go About Rebalancing Your Portfolio
Rebalancing your portfolio involves selling asset classes that have too high an allocation relative to your desired mix and using those funds to buy more assets in the classes that are allocated below your target level. In our earlier example, you would sell enough equities—and use those funds to buy bonds—to bring your asset allocation back to the desired 50/50 mix.
The degree to which you rebalance your portfolio is based on the percent allocation across each asset class, not the total value of your investments. Regardless of whether your portfolio has gained or lost value, you rebalance it based on how far the asset allocation has drifted from your intent.
The percentage of imbalance in our earlier example—56.7 percent stocks and 43.3 percent bonds vs a desired mix of 50/50—may not seem very great. Yet, over time a portfolio can drift from its intended allocation even more significantly. If we take our original example out another year, and this time stocks return an average of 9 percent and bonds an average of 2 percent, the portfolio allocation would end up at 58.3 percent stocks and 41.7 percent bonds. In just two years, our fictitious portfolio would have drifted quite far from the original asset allocation of 50/50.
When Is It Time to Rebalance Your Portfolio?
Since it’s inevitable you’ll need to rebalance your portfolio at some point to keep your assets allocated in line with your goals, exactly when should you take this step? Rebalancing your portfolio at specific intervals, such as quarterly or annually, or adapting, as needed, to market changes at two different approaches you could take.
One technique that is sometimes used to bring a portfolio back into alignment is auto rebalancing or scheduled rebalancing at specific intervals. Auto rebalancing can be beneficial on several fronts: It ensures your portfolio weights stay within acceptable variance levels without constant monitoring; it helps you stay disciplined and avoid the natural temptation to buy an asset as the price goes up and sell an asset as the price falls; and it removes the human behavioral element that can cause investors to become too greedy during market surges or too fearful during market downturns.
However, we know that market variances are unavoidable and unpredictable—with event-driven changes (like a natural disaster that disrupts energy supplies) and black swan events (like the pandemic) always looming as a possibility. For that reason, large market fluctuations between auto-rebalancing intervals could cause your portfolio to become out of alignment for a period of time.
An alternative approach would be to rebalance your portfolio by reacting and adapting to market changes as needed, rather than at pre-set time intervals. By continually monitoring your portfolio’s weighting across different asset classes and adjusting the allocation whenever the weighting exceeds an acceptable variance level, you can keep your portfolio aligned with your goals while minimizing the risk of under balancing or over balancing certain asset classes for an extended period of time.
How Much Portfolio Imbalance is Too Much?
In deciding whether your portfolio is imbalanced enough that it warrants rebalancing, there are no hard-and-fast rules. When creating an investment portfolio, consider setting target weights for each class and an acceptable level of variance to allow for the inevitable ebbs and flows of the market. Then if the weighting of a particular asset class breaches the acceptable variance level, we rebalance the portfolio.
For instance, if you set a weighting of 60 percent stocks and an acceptable variance level of 4 percent, and stocks now make up 66 percent of your portfolio, that would trigger a rebalancing event.
Choosing an acceptable variance level is a critical consideration and one that a financial planner may be suited to help with. If you choose a variance level that is very low, you can end up over balancing—with short-term capital gains eroding your returns. Conversely, if you set your acceptable variance level too high, you can end up under balancing—allowing your portfolio to become very misaligned with your goals. Choosing a variance level between those extremes results in a plan you’re more likely to stay on course with throughout the market’s cycles.
Since your desired asset allocation drives your portfolio balance, it’s important to revisit that allocation periodically, too, to ensure it continues to reflect your risk tolerance and investing time horizon. For example, as you approach retirement you may want less exposure to equities to reduce your risk during the years you’ll be drawing down your investments to fund your living expenses. On the other hand, if you’ve recently received a windfall, like an inheritance, you may feel comfortable with more exposure to stocks than you were before.
Rebalancing Your Portfolio and Taxes
The primary goal of rebalancing your portfolio should be to manage your investment risk in line with your risk tolerance. At the same time, rebalancing could cause tax implications. Consider how tax-advantaged retirement accounts, like an IRA or 401k, tax-loss harvesting, and new portfolio contributions can be as part of your rebalancing strategy to help improve tax-efficiency.
Need help crafting a rebalancing strategy to keep your portfolio aligned with your goals? Schedule a call with a Marshall Financial CERTIFIED FINANCIAL PLANNERTM professional for a personalized consultation.