A confession – I have never rebalanced my portfolio. Why? Because long term, investing in stocks beats investing in bonds or cash. During downturns I definitely feel those 30% drops in the pit of my stomach. And every time it’s happened, I’ve wondered if this was different, should I sell? The COVID sell-off really tested my ability to not act rashly. But somehow I’ve repeatedly ignored the fact that a third of my money had simply vanished and soldiered on.
According to the popular financial press, the ability to stay invested puts me in the minority. Most people would instead have sold at just the wrong time (when stocks were low) then waited too long to reenter the market (when stocks were nearing peaks again). Periodically rebalancing the portfolio can help people who panic when the market turns down.
What is rebalancing?
Let’s take a popular asset allocation for younger investors – 80% stocks, 20% bonds. If you invest $10,000 at one time in this portfolio, you would have $8,000 in stocks and $2,000 in bonds. Over a few years, your stock investment increases to $14,000 while your bonds come in at $2,200. That means, your overall asset allocation has changed to 86.4% stocks and 13.6% bonds. Many financial experts would suggest you sell some of your winning stocks and purchase bonds.
When to rebalance
Note that I didn’t say all financial experts suggest rebalancing. Some say do it yearly, no matter if it’s a 1% difference or 10%. Others say have a percentage in mind – maybe you rebalance when one asset class is 10% more or less than what you set as your goal.
How to rebalance
When you think of rebalancing your portfolio, you may think of selling stock (using our example above) and buying bonds. And while that’s one option, many experts suggest you put new money into the lagging category. In other words, if you are investing throughout the year and find that stocks are outperforming, consider putting new money in the bond allocation to bring it closer to the set goal.
Why you should rebalance
Manage volatility. I mentioned this at the top, but most people aren’t going to want to watch their portfolio drop by a third, much less watch it happen more than once during their lifetimes. Therefore, they are willing to sacrifice potential return for a less volatile portfolio. If one investment grows in value relative to the overall portfolio, an investor may be exposed to more risk. Rebalancing reduces this back to a level at which the investor is comfortable.
Manage emotions. I’ve written before about how hard it is to make a sell decision, especially after you’ve fallen in love with an investment. Regularly scheduled rebalancing removes that emotion; it becomes merely an exercise to realign your portfolio. You can choose a set time (say every year) or amount of imbalance (say 10%) but stick to this trigger. Don’t let emotions creep in.
Why not rebalance?
Costs. The more often you rebalance, the more you will have to pay in commissions, fees, and taxes. Don’t enter into this decision lightly, especially when trying to limit the tax bite. Evaluate all assets in the oversized allocation to determine the most advantageous way to rebalance while watching costs.
Reduced returns. Especially with stocks, making the decision to sell based on an arbitrary date or percentage can reduce your overall returns. Recent returns are a perfect example. Several tech stocks have been leaders in the S&P 500 since the COVID economic recovery began. If you owned one of them it could have easily doubled or tripled, quickly triggering your rebalance decision. Yet if you sold when it hit the set percentage, you ended up selling a stock that was still performing well for no reason other than it was “time” to sell.
If you choose to rebalance
- Consider rebalancing only when your allocation is off by a large percent (say 10%) and then no more than yearly.
- Look at expectations for your investments and consider selling only those that no longer match your goals.
- Make sure you identify the investments to sell that will cost less and provide as much of a tax savings as possible.
- Better yet, put new money into your underweighted asset class. Here too, look closely at your options. If your bond percentage is low and you want to purchase more, consider other types of bonds that may have more upside potential.
Rebalancing is a personal decision. If you have a long enough time horizon you may decide it’s not necessary. Some famous money managers have come to the same conclusion. For instance, John Bogle once said, “I am in a small minority on the idea of rebalancing. I don’t think you need to do it.” Whatever you decide, consider your options and make sure you are thinking through the process step by step.
Photo by Jules A