Investing often feels like a balancing act between the desire for growth and the fear of loss. It is completely normal to wonder if you should tweak your investments when the market moves or if you should just sit tight. We are here to validate that feeling and help you build a strategy that lets you live your life without constantly checking the stock ticker.
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. When you develop an investment strategy, the goal is to balance an appropriate return with a level of risk that lets you sleep at night.
In its simplest form, this boils down to your asset allocation, or what percentage of your money lives in stocks versus 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.
As these different asset classes move around based on their returns, your overall allocation can drift out of balance. This means you could end up with too much stock exposure and too much risk. Rebalancing is the simple act of making adjustments to bring your investments back to your desired allocation.
How rebalancing actually works
Rebalancing is as simple as selling the winners to buy the losers. That seems counterintuitive, but there is a good reason to do it periodically.
Let's look at an example.
Assume your portfolio starts with 80% in stocks and 20% in bonds. If stocks perform well in a given year, they become the "winners" of that period. You might wake up to find you now have 90% of your portfolio in stocks and only 10% in bonds.
In this scenario, your portfolio has taken on excessive risk. To rebalance, you would sell enough stocks to get your investment down to 80% and use those proceeds to buy bonds to bring them back to 20%. By selling the winner and buying the loser, you are realigning your portfolio with your original roadmap.
3 factors to consider
When you approach this process, you need to consider three things:
- Desired allocation: The specific weighting of each position (like stocks vs. bonds).
- Desired method: Whether you will rebalance based on a set time period or a specific weighting threshold.
- Execution strategy: How you will calculate and execute the trades required to buy and sell.
Why rebalancing matters for your money
The goal of investing is to grow your money so you can make work optional one day. To do this, you need to balance returns with your ability to tolerate volatility. Rebalancing helps in three main ways.
1. Maintaining the right allocation
If your roadmap calls for a mix of 60% stocks and 40% bonds, it is important to maintain that allocation over time. If your portfolio becomes too conservative, you might not reach your goals. If it becomes too aggressive, you might face too much risk.
2. Controlling risk levels
Risk is essentially the uncertainty around your ability to achieve your goals. Higher stock exposure generally means higher risk and larger swings in value. If you experience a downward swing right when you need the money, it could put your entire roadmap at risk. Rebalancing keeps this exposure in check.
3. Staying disciplined
A key to success is avoiding emotional mistakes during market volatility. Rebalancing forces you to sell high and buy low, which is the opposite of what many emotional investors do. It helps you stay the course over the long term.
The risks of skipping this step
What happens if you just let your portfolio drift? There are three main consequences.
Too much risk: Without rebalancing, you may expose yourself to greater losses than your roadmap can withstand. Risk is really about your exposure to losses or the uncertainty that your money will be there when you need it.
Lack of diversification: Investors often focus on winners. Without rebalancing, your portfolio could end up overly concentrated in just a few investments. This defeats the purpose of diversification, which is meant to help you weather different economic periods.
Deviating from your roadmap: Your strategy is the foundation of your financial life. Without rebalancing, your portfolio will stray from that original strategy and potentially jeopardize your ability to achieve your goals.
How often should you rebalance?
There are two primary ways to approach this.
Time-based rebalancing
This method is straightforward. You choose a schedule, such as quarterly or annually, and bring your portfolio back to the desired allocation every 6 or 12 months. It doesn't matter how the investments performed; you simply stick to the schedule. If your 60/40 portfolio drifted to 62/38, you rebalance back to 60/40.
This is the easier strategy to implement since it doesn't require constant monitoring. However, if markets experience a big downturn mid-year, you could find your portfolio far from your desired allocation before your scheduled date arrives.
Threshold-based rebalancing
Here, you set a range for how far an investment can drift. For example, if your strategy calls for 60% in stocks, you might decide to rebalance only when that position becomes greater than 70% or less than 50% of your overall portfolio.
Many professional money managers use this approach because they have the technology to monitor it. Studies have shown that threshold-based rebalancing can be superior to time-based approaches when it comes to managing risk.
Other factors to keep in mind
Adjusting over time
Your allocation isn't static. As you get closer to a goal like retirement, you will naturally want to lower the overall risk in your portfolio. This often means lowering your stock allocation and increasing bonds and cash.
Minimizing taxes
If you are rebalancing inside a 401(k), IRA, or Roth IRA, you don't need to worry about taxes since you don't pay them while money remains in the account. However, in a taxable investment account, selling winners creates capital gains, which may be taxed. You can use strategies like tax-loss harvesting to help manage this.
Rebalancing with new money
Another smart way to rebalance is to simply direct any new contributions to the asset classes that have underperformed. If bonds are below their target weight, use your monthly deposit to buy more bonds rather than selling your stocks.
The Facet difference: Keeping your roadmap aligned
At Facet, we believe that your investments should serve your life, not the other way around. Our membership model gives you access to a CFP® professional who looks at your entire financial picture, not just your investment accounts. We help you build a personalized roadmap that accounts for your risk tolerance and goals, and we use powerful technology to help keep your portfolio on track.
We don't charge a percentage of your assets, which helps ensure our advice is aligned with your best interests. Whether you use a time-based or threshold-based approach, we are here to ensure your money is working as hard as you do to achieve self-fulfillment.
