Don't put all your eggs in one basket. That's the idea behind diversifying your portfolio and balancing your investments. When you balance your investment portfolio, you may decide to put, say, 60% in stocks, 30% in bonds and 10% in cash. Ideally, the balance formula you follow aligns well with your risk tolerance.
Eventually, however, market conditions can cause a well-balanced portfolio to fall out of balance. Perhaps your Google stock delivers a higher rate of return, and your stock investments now represent 70% of your portfolio. In this case, rebalancing your portfolio can help you restore your portfolio to match your original balance.
Rebalancing is when you reallocate your investments to match your original asset allocation. Rebalancing your portfolio helps you stick to your investment plan and keep your investments in line with your risk tolerance levels—regardless of what happens with the market.
Let's go over how rebalancing your portfolio works, its advantages and disadvantages, and the best time to do it.
How Rebalancing Works
Rebalancing is the process of buying and selling portfolio assets to help you maintain the balance of investing risk suitable for you. It helps you restore your portfolio's balance to its original plan when market returns knock your asset allocation out of whack.
Rebalancing is a relatively simple process: Periodically, you'll cash in some profits on overperforming stocks or other assets and reinvest the proceeds in underperforming assets.
Let's say you have a portfolio with a mix of 60% stocks and 40% bonds. Going a step deeper, your 60% in stocks is subdivided into 50% large-cap stocks, 30% mid-caps and 20% small-caps. Similarly, your bonds are divided equally between U.S. government bonds and corporate bonds.
What if some of the large-cap stocks in your portfolio perform exceedingly well, bringing your stock weighting to 70% and your large-cap allocation to 40%? In this case, you might rebalance by cashing out assets from large-cap stocks and reinvesting them in bonds to bring your portfolio back in line with your desired 60/40 balance position.
Alternatively, you could direct more money, or add new investments, into bonds until your portfolio reaches its original allocation percentage.
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Pros and Cons of Rebalancing
Rebalancing your portfolio can help you manage risk by maintaining a healthy balance of high-risk and low-risk investments. But, if you're unsure whether rebalancing is a suitable option for you, consider these pros and cons of rebalancing:
- Realigns your portfolio with your risk tolerance: Rebalancing minimizes the impact of the individual assets in your portfolio. When a single investment outpaces your other investments in value, your exposure to risk may be higher than you would like. Rebalancing restores your investments to your original balance ratio and helps offset your portfolio's risk of declining value.
- Removes emotions from investment decisions: There's an old saying on Wall Street that the market is driven by two emotions: fear and greed. Successful investing typically requires a more disciplined approach that removes emotion from the equation. Your investment decisions are instead based on the allocation balance you've already decided meets your level of risk tolerance.
- Doesn't require a lot of time: You don't have to rebalance often to be effective. In fact, the Financial Industry Regulatory Authority (FINRA) suggests rebalancing once a year as part of an annual review. Some advisors recommend rebalancing when your balance shifts by a specific degree, such as 5 percentage points.
- Helps you buy low and sell high: Rebalancing involves selling assets with significant growth and investing in assets that are positioned to grow.
- May not work as well with individual stocks and bonds: Individual equities and bonds could potentially lose their value, so consider using broadly diversified funds.
- Could trigger capital gains taxes: You won't face unwanted capital gains tax when you rebalance inside an IRA, 401(k) or other tax-deferred account. However, other investments you hold for less than a year before selling are usually taxed at regular income tax rates. Some tax experts recommend selling investments that haven't panned out to counterbalance your gains from winning assets.
- Potential increase in trading costs: During times of extreme market volatility, you could end up rebalancing your portfolio many times and paying more transaction fees in the process.
When to Rebalance Your Portfolio
It's widely recommended to review your asset allocations in quarterly or annual intervals. The idea is to avoid knee-jerk reactions to short-term market fluctuations while keeping your eye on allocation shifts in your portfolio. While you're reviewing your asset balance, you can also evaluate the return-on-investment (ROI) on your assets and decide whether to redirect your investments elsewhere.
In times of broad shifts in the market, it may make sense to rebalance when your asset allocation changes significantly instead of sticking to the calendar. For example, you may set a 5% or 10% marker and rebalance whenever one part of your portfolio shifts by that much in either direction. Sure, you may miss out on market peaks with your investments, but you'll also take profits and limit your risk exposure.
If you're investing through your company's 401(k) retirement plan, your investments are likely to be regularly and automatically rebalanced by plan managers. Similarly, many digital management options from online brokerages, such as E-Trade and Schwab, offer interval and automatic portfolio rebalancing to ensure your asset allocation stays on track with your investment goals.
Don't Lose Your Balance
It's easy to end up with an unbalanced portfolio. Since stocks typically increase in value faster than bonds, stocks can end up "taking over" your portfolio. You're likely to take on additional risk without rebalancing because a more significant portion of your portfolio will be higher-risk investments. Rebalancing restores balance to your investments and diversifies your portfolio.
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