Benefits of Rebalancing

Sep 10

Diversifying your investment portfolio means putting together a mix of stocks, bonds and other investments with your financial goals, time horizon and risk tolerance in mind. Your mix is called your asset allocation. The idea behind diversification is that, overall, owning different kinds of investments should earn you higher returns with less risk than holding any individual investment.

Establishing the mix, or asset allocation, right for you is one of the most important factors in determining long-term investing success. But then you must do the ongoing maintenance necessary to produce your desired results and control your risk. This occurs through a process called rebalancing, which restores your portfolio to its original asset allocation and risk profile.

Each investment in your portfolio will increase or decrease in value at varying rates, changing your asset allocation. Asset classes, or groupings of similar types of investments, will have months, years or even decades when they outperform or underperform other asset classes. Examples of major asset classes are stocks or equities, bonds or fixed-income investments, and real estate or other tangible assets. Each major asset class can be further categorized into greater detail. For example, equities can be broken into large cap, small cap, U.S. (domestic), international, growth, value and other buckets.

Think about it like preparing a balanced meal to include a protein, vegetables, fruit and grains. Specifically, you could have chicken, asparagus, watermelon and whole wheat rolls. Or you may want BBQ ribs, french fries, roasted peppers, cantaloupe and chocolate cake.

You can rebalance in a couple ways. You can get back to your desired asset allocation when you add or withdraw funds. A way to generate cash is to let dividends pay out instead of automatically reinvesting. Another method is to sell investments in an asset class that has increased in value beyond its set percentage and purchase investments in asset classes that have declined in value.

You do not want to rebalance too frequently, and you certainly want to be aware of whether doing so will generate taxable income. Rebalancing with added cash has its advantages. This can limit the number of trades you need to make (and thus trading costs) and minimize taxable capital gains. You may want to delay rebalancing if it incurs short-term capital gains, as they are taxed as ordinary income. If capital losses can be harvested, you want to take advantage of that situation.

Let’s look at a brief, hypothetical example of how rebalancing works. Ron and Sally set a desired asset allocation of $500,000 of equities and $500,000 of fixed income for their $1 million portfolio. Their target is to stay within 5% of this 50% stock and 50% fixed income mix. Over the past two years, equities have performed well, and this portion of their portfolio has grown to $700,000. Their portfolio’s fixed income value also has risen, to $530,000. They now have a portfolio worth $1.23 million with 57% in equities and 43% in fixed income. This new allocation has too much risk for them, and they decide to sell $85,000 of equities and reinvest that cash into fixed income to restore their original 50/50 allocation.

Another benefit of knowing your portfolio is built to maintain a risk profile that you can tolerate is the calm and peace of mind it will lend you in years like 2020, when volatility has been higher than in the recent past and abandoning stocks may have looked tempting.

Using a diversified portfolio that you monitor and rebalance periodically will help you stick to your investment strategy and manage your risk.

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This article is written by Connie Brezik and is for general information only and is not intended to serve as specific financial, accounting or tax advice. IRN-20-776

James Yarbrough