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Your investment portfolio should reflect your long-term goals, retirement timeline and risk tolerance. When taken together, these factors can help you settle on an asset allocation that feels right for you. It will likely include a mix of higher-risk investments and safer, more stable securities. This provides balance and can keep your portfolio on an even keel as you move through your working years and beyond.
But over time, a portfolio that started out as balanced can become lopsided as the value of your investments and your tolerance for risk changes. Rebalancing your portfolio brings things back into alignment. There are two primary ways of doing this: selling off high-performing investments and redirecting the returns, or pumping additional funds into asset classes that need a boost. The best strategy for you will depend on your financial situation, but understanding how rebalancing works is the first step.
The Risks of Having an Imbalanced Portfolio
Your investment portfolio will likely carry the bulk of your nest egg. It can include assets like:
- Individual stocks
- Mutual funds
- Exchange-traded funds (ETFs)
- Real estate
- Alternative investments such as cryptocurrency, private equity or hedge funds
Assets can be spread across different investment vehicles, such as a 401(k), individual retirement account (IRA) or regular brokerage account. They all come together to create your investment portfolio.
Incorporating higher-risk investments is often necessary to net better returns, grow your wealth over time and keep pace with inflation. To offset that risk, you can mix in safer investments to shore up your portfolio. Bonds, high-yield savings accounts and certificates of deposit (CDs) all fit into this category. Returns are typically lower with these investments, but they can provide reliable income and some much-needed stability.
Striking the right balance is key to meeting your long-term financial goals. Playing it too safe can hamper growth and prevent you from generating the kind of returns you need. On the other hand, investing too heavily in high-risk assets can lead to major losses if they don't work out. One rule of thumb is to stick to a 60/40 portfolio—60% stocks, 40% bonds. According to investment research company Morningstar, this type of portfolio had an average annualized return of about 10% between 2010 and 2020.
You may feel comfortable assuming more risk if you're young and have more time to bounce back from market volatility. An experienced financial professional can guide you in finding the right asset allocation, but it isn't a set-it-and-forget-it thing. As the value of your investments shifts and changes with regular market performance, your portfolio can be thrown off kilter. Periodically rebalancing allows you to reset your assets so that they reflect your desired risk level and goals.
How to Rebalance Your Portfolio
There are a few ways to bring your portfolio back into balance. Below are the most common approaches:
- Funnel stock dividends toward underperforming asset classes until you reach your desired allocation.
- Purchase new investments within underweighted asset classes until things balance out.
- Sell portions of high-performing assets and redirect the money toward asset classes that you want to lean into. A financial advisor can help you decide what to offload.
Let's say your desired asset allocation is 70% stocks and 30% bonds. Over time, you may notice that your portfolio has slid to a 75/25 split. You could use one of the above strategies to restore your desired balance, potentially by selling off stocks and buying bonds.
This also applies to investors who've been adhering to dollar cost averaging, which has you contribute a set amount into an investment account at regular intervals. When the market is performing well, this will buy you fewer shares. During market dips, you'll acquire more. After a while, your portfolio could become imbalanced.
Just be mindful of potential costs. Selling investments from a taxable account could put you on the hook for capital gains tax. However, you might sidestep it by rebalancing strictly within tax-advantaged accounts.
When to Rebalance Your Portfolio
It's wise to revisit your asset allocation annually. Use this time to see if your investment portfolio still aligns with your risk tolerance and supports your long-term financial goals. If you're close to retirement, a financial advisor may recommend tweaking your allocation.
Retirees generally have less time to recover from bouts of market volatility. As such, they may opt for a more conservative allocation. This doesn't mean doing away with risk altogether—taking on some degree of risk may still be necessary to keep up with inflation. In truth, you can revisit your asset allocation whenever your risk tolerance changes.
Target-date funds (also called lifecycle funds) gradually adjust their allocation for you. As the years go on and you get closer to retirement, it will automatically shift toward a more conservative mix of investments. Just be sure you understand a lifecycle fund's fees and investment approach to make sure it gels with your overarching investment plan.
The Bottom Line
Rebalancing your portfolio is par for the course when you're investing for your future. The endgame is to make sure your investments continue to support your long-term goals. It's one part of your financial big picture. Maintaining healthy credit along the way is just as important. Experian makes this part easy, offering free access to your credit report and credit score whenever you need it.