It's the Season to Rebalance!


It's something we've heard a million times throughout the years- don't forget to rebalance your portfolio.  But what does that actually mean?  Rebalancing is the process of restoring your portfolio to your target allocation set out at its inception. And even those of you who do not make a single trade during the year can find your allocations out of whack- as certain investments gain they will take up a greater percentage of your portfolio during the year while others decline in value and decrease proportionally within the portfolio.  

So many will question:  why would I cut down on the winners just to give to the losers?   However, no matter how unnatural that practice may seem, the rebalancing process is an essential part of managing your investment portfolio.

If your investment goal hasn't changed, your portfolio's mix shouldn't either. Rebalancing is about risk control- making sure your portfolio isn't too dependent on one asset class or investment. No one investment style stays in favor forever and that's the point of rebalancing- to help you reap the full rewards of diversification- to trim back on winners secures gains and allows you to buy the laggards positioning your portfolio to benefit when the market changes who the new favorites will be. 

Below is a quick 3 period change and rebalancing adjustment.  In effect, we have sold the winners (yellow and green) to buy the losers (blue and red).

Rebalancing can also manage sequence of return risk- the risk that an ill timed correction in the market can severely diminish the length a portfolio will last in retirement.  By rebalancing, you are in effect selling high and buying low (rule number 1 in investing!).  If we look at the flow chart below, we can see how the as the market changes, you are automatically following this mantra:


This can force investors to sell the hot stocks and buy the lower priced ones- even those who rarely if ever look at their investment's performance.

So How Do We Do It? And When?

First off, we have to understand what we mean when we say "portfolio".  This is referring to everything you have accumulated over the course of your lifetime:  IRAs, 401Ks, brokerage accounts, and even those old bonds stored away in a safety deposit box somewhere.  This means using financial tracking software, spreadsheets, or if possible, one financial institution so you can see the whole picture at once.  

There is a short checklist on what to do:

1) Review your original target allocation - This was the allocation you set it at.  However, does this allocation still apply?  Did you make this allocation when you were 26 and single, but now find yourself married with children in your late 40s?  It may be time rethink what your optimum target allocation is for your current circumstances.

2) Now Compare your Target Allocation to the Current Allocation and determine what's out of whack! - Using the new allocation, determine the differences. First exam the cash/ bonds to stocks ratio.  This is the first item that would get out of whack since its the most vague and generalized in category. Next examine the style box mix- have small and midcaps outperformed large caps, or vice versa?  What about international? Lastly, consider sector exposures.  Has technology been on a tear and now takes up a much larger percentage of your mix?  

3) Adjustment Methods - There are two main methods for rebalancing:

Time- Based Rebalancing- this is where every so often you check in on your portfolio and determine if it needs rebalancing. 


Percentage-based Rebalancing- This method is used when the allocation changes X percentage over a period.  The 'normal' threshold is 5% but any percentage can be used (we don't recommend below 5%).  

It is important to understand that this exercise shouldn't be done weekly or monthly- or probably not even quarterly.  At best it's a yearly exercise.  And even then it should only be done if truly necessary.  Has your portfolio’s allocations to stocks and bonds diverged from your target allocation by five percentage points?  Then you may consider rebalancing.  Any less and most would say not to bother.  Research even suggests that those who rebalance too often performed slightly worse than those who used the 5% or more rule.

The lazy man's rebalance would be to at a minimum rebalance the stock/ bond split.  If they diverge greatly from their original allocation, restoring them would reduce overall portfolio risk greatly. 

Mistakes to Avoid!

Lets peruse a few common mistakes that investors should avoid...

  • Don't become obsessed!  Again don't over do it...  annually should be sufficient unless huge swings occur. 

  • Stay the course...  there is a reason why we use allocation mixes based on age, tolerance, etc.  It keeps investors from moving to one side of the ship too much. 

  • Don't fall in love with one stock or asset class.  Throwing good money after bad because you want to see your the investment pop back or because you don't want to sell for a loss can exacerbate losses.  Have a preset sell level ready.

  • Don't only focus on the losers;  Like we mentioned above, the winners could expose you to too much risk.

  • And lastly, when rebalancing within a brokerage account remember you are creating a taxable event.  So be aware of tax consequences when selling.