Portfolio Rebalancing: Why You Change Your Asset Allocation
Unless you are over 100 years old and were around to invest in small brands like General Electric (GE) or tech stocks before they became a massive hit, your investment portfolio probably does not consist of one major player that earns all of your income. Like most people, your assets are probably distributed across a diverse playing field to maximize your income while minimizing your exposure to risks. Even if your portfolio is already well balanced, there is a case to be made for rebalancing the field from time to time.
The process of rebalancing helps to restore your portfolio to a target asset allocation setup. This does not necessarily mean divesting from your high-performance stocks and funds, or even creating imbalance by investing more in those funds. Instead, rebalancing is the act of adjusting your portfolio to restore the original balance you sought to achieve. Market forces sometimes create imbalance by altering the values of different classes of stocks/bonds/funds, and by rebalancing you can offset that to restore order in your asset allocation.
Approach to Rebalancing
USNews offers a helpful starting point as you look to rebalance your asset allocation. The first step for most is to create a master list of your investments. This allows you to see what percentage of your investments apportion to stocks and bonds. Looking at all of your investments together gives you a clear picture of the amount of investment in and value of each fund.
From here you can determine what your desired asset allocation is, and take the appropriate steps to rebalance your portfolio so its matches up with that vision. Now you can start by redirecting money to lagging asset classes until such a time as those funds rebound to reflect a percentage of your total portfolio that was originally intended.
You can also add new investments to lagging asset classes and contribute a larger percentage of contributions here. Again, you can do this temporarily until those classes meet a point at which you have restored the original balance you sought in your portfolio. Lastly, consider selling off portions of holdings with the asset classes that are outperforming others. That will give you profits to reinvest in your lagging asset classes.
Consequences of Imbalance
You cannot rely on the past performance of any class (mutual funds/stocks/bonds/etc.) to indicate what the future performance of that class will look like. For example, equities are more volatile than fixed-income securities. The gains you enjoyed last year could quickly translate to losses over the next year. Additionally, you can expect your assets to grow at different rates. This is a primary contribution to imbalance in your portfolio to begin with. The biggest problem here is that it could result in your portfolio carrying a greater percentage of risks and fewer long-term return funds.
When to Rebalance
There are many schools of thought on the subject of frequency. Bankrate notes that the worst thing to do is rebalance during extreme highs or lows in market performance. Rebalancing needs to take place with your eyes on the prize: retirement. Asset allocation should always reflect your goal's timeline: in other words, how much time you have between you and retirement.
When to rebalance, specifically, depends on transaction costs, personal preferences, and tax considerations. This can include the type of account you are selling from and whether or not you will face capital gains/loss impacts in the short and long term. A good rule of thumb is to consider annual rebalancing of your portfolio. Contact Paul Miller, CFP®, today to help get your rebalancing started.