Investing requires discipline, and this discipline involves regular attention.
Portfolios should be designed to manage risk through diversification — by including different types of assets in the right proportions to suit your personal risk tolerance, goals and time horizon. By not having too many of your portfolio dollars allocated to any one type of investment, you lessen the risk posed by a particular type plummeting in value.
You can take great care to build a well-diversified global investment portfolio designed to get you through any kind of market weather year in and year out, but if you don’t maintain your asset allocation, your portfolio can change into a creature you may not recognize. As a result, it may no longer do the job of risk management that you designed it to do.
So, you need to rebalance. Let’s say your allocation calls for 70 percent of the dollar value of your portfolio in stocks and 30 percent in bonds. But if your stocks do well, their value could increase to 80 or 90 percent of the dollar value of your portfolio. Then, you’d be over-weighted in stocks, taking more risk because of increased exposure, beyond what you’d originally intended, to possible events that could roil the market. (Such events can be particularly perilous when they occur close to retirement. If the market doesn’t recover soon enough, you could be selling shares when they’re down to pay living expenses.)
The same concept applies to allocations within a given asset class — stocks, for example. Let’s say your allocation calls for 50 percent in shares of a large-cap stock index fund and 25 percent each in small- and mid-cap funds. Let’s also say that your small- and mid-cap funds have decreased in value while the large-cap funds in your portfolio have increased since you established your portfolio (or since you last rebalanced). Then, rebalancing involves selling appreciated shares of the large-cap funds while they’re up and buying small- and mid-caps while they’re down. Thus, while rebalancing, you sell high and buy low — Investing 101.
Far trickier than knowing how to rebalance is knowing when. Some investors rebalance annually, but this may not really be warranted. A more beneficial approach is to rebalance dynamically – only when your allocation gets too out of balance. But even then, you may want to rebalance later or sooner, depending on a number of factors. These factors include:
Trading costs. Depending on how much these are and how much you need to rebalance, these costs may be a factor influencing when to do so.
Tax consequences. If rebalancing involves selling assets in a taxable account, this could trigger capital gains tax. Whenever possible, make every attempt to hold investments for a minimum of one year to avoid short-term capital gains, which are taxed as ordinary income. Investments held for more than a year are generally taxed as long-term capital gains, typically at a much lower rate than short-term gains. This might be a reason to make rebalancing moves involving taxable accounts less often.
A steep increase or decrease in the stock market. If you tend to rebalance (if needed) once a year, depending on your specific allocation, such an event could be a good reason to rebalance sooner or later than you’d planned.
These considerations aside, the ideal scenario is to just establish what amount of drift (by percentage), outside your initial target allocations, that you’ll allow before triggering rebalancing. Then, you can just rebalance when these limits are exceeded — or when your goals have changed.
Tim Decker is president of ISI Financial Group, a wealth management firm in Lancaster, and a fee-only financial planner. His weekly call-in radio show, “Financial Freedom,” airs Saturdays at 10 a.m. on WHP 580 AM.
This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it is not intended to provide specific financial advice. Investing involves risk, including the loss of principal. Past performance is no guarantee of future performance. You should always seek professional guidance before making any financial or legal decisions, as everyone’s needs are different.