The end of the year is full of the hustle and bustle of the holidays, but it’s also a great time to “clean up” your investments. Regular portfolio rebalancing is one way to maintain proper allocations and risk alignment for your unique financial situation.
We believe rebalancing your portfolio is critical to protecting your investments, especially if you’ve had a year full of big decisions, such as buying a home, car, or even a medical practice.
So, what does it mean to rebalance your portfolio? How does it work? How often does it happen? Let’s explore!
What’s Portfolio Rebalancing?
Many new vehicles have a feature that alerts you if you’re nearing a lane marker, like crossing over into another car’s path. Portfolio rebalancing is similar to that vehicle safety feature—keeping your investments in the proper lane. It’s a practice that may help you maintain the proper asset allocation for your financial situation through buying and selling securities.
The right asset allocation will require you and your financial advisor to look at your investments comprehensively—stocks, bonds, mutual funds, real estate, and alternative investments. Together, you will analyze significant factors such as your risk tolerance, risk capacity, time horizon, and long-term and short-term goals to determine the best investments for you.
As with all stages of your financial plan, your portfolio can change with time and circumstances. For example, your desired asset allocation may look different when you’re a new grad fresh from residency or a seasoned pro on the precipice of retirement—and it probably should! Your financial journey is all about growth and embracing new stages and opportunities in your life.
Why Would You Have To Rebalance Your Portfolio?
You and your advisor spend a lot of time and energy constructing a portfolio that suits your needs. But once you have it, you might not benefit from putting your portfolio on autopilot.
Why?
Because markets change. Market volatility is nothing new, so while you may have had a suitable allocation earlier in the year, the tables could turn if the market changed dramatically, causing some investments to tumble and others to flourish.
For example, say your long-term target is 80% equities and 20% bonds (we’ll keep it simple). But if stocks drop and bonds rise, you may find yourself with 70% equities and 30% bonds, which could take you too far off course, making rebalancing a solid option to consider.
Or, perhaps an investment you considered low risk a few years ago seems far riskier in today’s economic climate. Rebalancing your portfolio will allow you to reevaluate your risk tolerance and adjust the weight of that investment accordingly.
Keep in mind that rebalancing gets more complex depending on your current portfolio and future goals—but that doesn’t mean you should push it off. We believe it’s crucial to stay up to date with the status of your investments.
The Potential Benefits Of Rebalancing
Rebalancing your portfolio has a few key benefits. Let’s review.
- You can better manage your ongoing exposure to market risk. Rebalancing your portfolio isn’t about ‘beating’ the market, rather managing market risk and your risk tolerance.
- You can evaluate how your allocations are working for you. Rebalancing could open the door for tax opportunities like tax-loss harvesting—selling investments at a loss. You can use it to offset any gains you may also have from rebalancing.
- You can better track and reach your financial goals. When you know the state of your assets, you see the full financial picture. It can be nearly impossible to reach your financial goals without understanding the state of your assets. As a bonus, reviewing your portfolio should ensure that you and your advisor are on the same page. You can adjust your portfolio with your advisor if your goals have shifted.
Being informed and educated about your affairs should empower you to make the best financial decisions for you. By not rebalancing your portfolio, you may unintentionally leave your investment performance open to significant losses that you may not be ready for.
Understand The Tax Impact
While rebalancing can be a helpful component of your ongoing portfolio maintenance, it’s important to consider the potential tax impact of this practice.
For example, selling securities in a taxable account, like a brokerage account, could lead to capital gains tax in the year you sell the asset. The length of time that you’ve owned an asset will determine how your capital gains or losses are taxed.
From a tax perspective, there’s less red tape when rebalancing tax-advantaged accounts like an IRA or 401k, as the gains aren’t taxable until distribution in retirement.
How Often Should You Rebalance?
Now you know what rebalancing is and how it works, what’s the “right” cadence?
As with most areas of financial planning, the right time to rebalance varies from person to person. It depends on several factors such as:
- Risk preferences
- Long-term and short-term goals
- Life changes
- Taxes
- Fees
- Market movements
There’s no universal answer, though many benefit from regular rebalancing. For you that might mean quarterly, but for another person, that could mean annually. Work with your advisor to create a plan that makes sense for you.
The Bottom Line: Work With An Advisor You Trust
We believe rebalancing your portfolio is critical for your financial health. This process should ensure you can reach your financial goals and make more informed investment decisions.
Related: Time or Money-Weighted Returns, Is One Better Than the Other?