What is portfolio rebalancing?

When it comes to investing, there are a lot of decisions you need to make. How much should you save? Should you invest in a 401(k), IRA, Roth IRA, taxable account, or some combination? What should you invest in (stocks, bonds, real estate)? And what level of return should you expect given the level of risk you are taking? Your answers to all of these questions will determine the investment outcomes you achieve over time.

While there is a lot to consider when developing your approach to investing, the good news is that there are a few simple strategies you can use to make your investment experience easier. One of those strategies is known as portfolio rebalancing. Portfolio rebalancing is a strategy that can help you keep your returns on track and keep your risk in check. And when it comes to investing, the risk/return trade-off is all about finding the right balance. Here’s what you need to know about portfolio rebalancing and how to make this simple strategy work for you.

What is portfolio rebalancing?

Portfolio rebalancing means adjusting the amount of money you've invested in certain stocks, bonds, or any other asset to protect yourself from new risks caused by changes in the markets during the year.

When you develop an investment strategy, the goal is to determine an appropriate investment return and to balance that return with a level of risk that is right for your plan and one you can tolerate (i.e. one that won’t keep you up at night).

In its simplest form, portfolio rebalancing boils down to what percentage of your money you will invest in stocks and bonds.

If you have a longer time horizon, you might put 80% in stocks and 20% in bonds. If you are closer to retirement, you might put 60% in stocks and 40% in bonds. This mix is also called your asset allocation (it’s what you allocate to different assets).

As the different asset classes in your portfolio move around based upon their respective returns, your overall allocation can become out of balance. This means you can have too much or too little stock exposure and, as a result, too much or too little risk, respectively, in your investment portfolio.

When this happens, your allocation (your asset mix) is no longer aligned with your overall plan which means your investments are out of balance with your strategy. Rebalancing is the simple act of making adjustments to what you own (selling what went up and buying what went down) to bring your investments back to the desired allocation.

How portfolio rebalancing works

Portfolio rebalancing is as simple as selling the winners to buy the losers. That seems counterintuitive, but there’s good reason to do that periodically.

Let’s look at an example.

Assume your portfolio is invested 80% in stocks and 20% in bonds. If stocks perform well in a given year (we can consider them the winners over that period) and you now have 90% of your portfolio in stocks (and 10% in bonds), you would sell enough stocks to get your investment down to 80% and use those proceeds to buy bonds to bring them from 10% back to 20%. In this scenario, your portfolio had excessive risk when it had 90% in stocks so by selling the winner (stocks) and buying the loser (bonds) you are realigning your portfolio and bringing it back in balance (rebalancing) with the desired allocation.

3 factors you need to consider when rebalancing a portfolio

1. The desired allocation, or weighting, of each position in the portfolio - In the above example, the portfolio only consisted of two holdings (stocks and bonds) to keep things simple.
2. Your desired method for rebalancing - More on this below, but this is about deciding how you will determine when you rebalance your accounts. You can do it based on a set period of time (quarterly, annually, etc) or based upon a specific weighting for each investment (also called a threshold approach).
3. Your strategy to execute the trades required - Once you have your weightings and how you will approach rebalancing, you need to determine how you will execute your trades. This is often the most challenging part as it requires you to calculate how much of different investments to buy and sell.

The concept of rebalancing is straightforward. It’s often the execution that can become a challenge. Let’s look at why you want to rebalance in the first place.

Why portfolio rebalancing is important

Going back to why we invest, the goal is to grow our money so that we can use it to provide income to cover our expenses at some point in the future – you can call this retirement or financial independence but the point is to make work optional. To do this, you need to achieve an appropriate investment return and balance that with a level of risk that fits your overall plan and your ability to tolerate the ups and downs of investing (also called volatility).

Rebalancing your portfolio helps in three main ways

1. First, rebalancing ensures that we maintain the right overall allocation of our investments. If your plan calls for a mix of 60% stocks and 40% bonds, it’s important to maintain that allocation over time assuming nothing materially changes in your life that requires an adjustment to the plan. If your portfolio becomes too conservative, you jeopardize achieving your goal because your return may not be enough to get you there. If your portfolio becomes too aggressive, you may achieve a higher return but you may also face too much risk.
2. Second, rebalancing is an excellent way to ensure your portfolio maintains the proper level of risk. And risk can be defined as either a loss of your investment or uncertainty around your ability to achieve your goals. Having greater stock exposure, which generally means you are taking on more risk, can lead to higher returns, but it can also lead to much larger swings in your portfolio value. If you experience a downward swing when you need the money, it could put your plan at risk. The right level of risk is critical to achieving success.
3. Third, rebalancing is a systematic way to ensure you remain disciplined to your plan and your overall strategy. A key to successful investing is to avoid the emotional mistakes that many investors make during periods of market volatility or downturns. Through the process of rebalancing, you can actually use volatility and downturns to your advantage, make sure you sell high and buy low (when many investors sell low and buy high), and make sure you stay the course over the long-term so that you achieve the best investment outcomes possible. 

What are the consequences of not having a balanced portfolio?

1. Too much risk 

At the end of the day, risk is really all about your exposure to losses in a portfolio or the uncertainty that your money will be there when you need it. If you don’t rebalance and keep your portfolio in line with the level of risk that is appropriate for your plan and what you can tolerate, you may expose yourself to greater losses than your plan can withstand.

2. Lack of appropriate diversification

Many investors have a tendency to focus on the winners in their portfolios. As a result, they often end up with too much money in one investment which defeats the purpose of remaining diversified and having a more balanced portfolio that can perform better during different economic and market periods. Without rebalancing, your portfolio could end up overly concentrated in one, or a few, investments and that could put your strategy at risk.

3. Deviating from your plan

The desired outcome from investing is to put you in the best possible position to achieve a future goal. The foundation of any strategy is the financial planning process that determines how much to save, the returns you need, and the level of risk that is appropriate. Remaining disciplined to the plan you create is a key element of success. Without rebalancing, your portfolio will stray from the original strategy and potentially jeopardize your ability to achieve your goal.

How often should you rebalance your portfolio?

There are two primary ways you can rebalance a portfolio:

1. Time-based rebalancing 

Time-based rebalancing is fairly straightforward. You choose how often you want to rebalance your investments (quarterly or annually as examples) and simply bring your overall portfolio back to the desired allocation every 6 or 12 months, respectively. It doesn’t matter how your investments performed. You simply schedule it and rebalance when that time rolls around. So if your 60/40 portfolio was only 62/38, you would rebalance back to 60/40.

2. Threshold-based rebalancing 

Threshold simply means you set a range for how far an investment can move, or drift from, the desired allocation or weight. For example, if your investment strategy called for 60% in stocks, you might decide to rebalance when that stock position was greater than 70% or less than 50% of your overall portfolio.

The easier strategy to implement is time-based rebalancing. It doesn’t require constant monitoring of your portfolio or calculating the percentages of each investment in your accounts.

However, it could subject you to more risk. If you are rebalancing annually, and the markets experience a big downturn mid-year you could find your portfolio to be quite far from the desired allocation.

You can rebalance more frequently to avoid this issue, but it’s generally not recommended to rebalance too often (weekly or monthly for example).

Many professional money managers will use a threshold based approach because they have the technical capabilities to execute on such a strategy. Studies have shown that threshold-based rebalancing can be superior to time-based approaches when it comes to managing risk.

Other factors to consider

Adjusting your allocation and risk over time

Keep in mind that any investment strategy, and overall allocation to stocks, bonds, and other asset classes should naturally be adjusted over time.

As you get closer to your desired goal (like retirement), you will want to lower the overall risk in your portfolio. In many cases this can be accomplished by lowering how much you invest in stocks and increasing how much you invest in bonds and cash.

Minimizing taxes when rebalancing 

If you are rebalancing accounts like a 401(k), IRA, or Roth IRA, taxes do not need to be considered since you do not pay taxes while your money remains in these accounts. However, if you have a taxable investment account, you need to be aware of any tax implications that a rebalance will create. As you sell the investments that have gone up in value, you will realize capital gains and possibly owe taxes on those gains. One way to help manage the gains that you realize is to implement a tax-loss harvesting strategy.

Rebalancing through additional investments

Another way to keep your overall portfolio in line with your desired allocation and level of risk is to invest any new money you add to your investments to the asset classes that have underperformed and that are below their desired allocation.

Final word

Rebalancing not only ensures that you're buying low and selling high, but also eliminates the temptation to time the market. Since we can’t consistently predict when an asset class has peaked, it’s impossible to know the optimum time to sell and maximize profits. By rebalancing your assets at least once a year, though, you’ll be taking full advantage of the movement of the markets. You’ll also be keeping your portfolio in line with your long-term financial plan, which of course is the ultimate goal.

A CFP® Professional at Facet, in concert with an experienced investment team and powerful technology, can help you develop a personalized investment strategy to support your ongoing financial plan.