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How to rebalance a portfolio

Keep your risk profile in line with your goals.

In an ideal situation, an investment portfolio is constructed by an individual or a financial professional with an eye toward accomplishing a goal or even a series of goals. That could mean anything from purchasing a home, to putting children through college, to providing for a secure retirement, or any number of other financial goals.

Portfolio drift

But over time, if left alone, the portfolio you’ve created to help achieve your goals could devolve and actually begin to hinder your ability to reach those goals. That’s because each asset class and market sector you own will perform independently – and differently – from each other.

Some investments may rise in value more than others, and some may fall in value more than others. And as time goes on, your portfolio will cease to resemble the asset allocation that was originally created. This is called portfolio drift.

That’s where rebalancing your portfolio comes in.

What is portfolio rebalancing?

Simply put, portfolio rebalancing involves buying and selling parts of your portfolio so that the weighting of each asset class stays consistent with the original weighting.

For example, let’s say that you originally constructed your portfolio with a 60% allocation to stocks and a 40% allocation to bonds, but over time, bonds outperformed stocks and now your portfolio consists of 45% bonds and 55% stocks.

To rebalance a portfolio, in this case, may include selling some bonds and using the proceeds to buy stocks. This helps you reset your portfolio allocation to the original 60:40 distribution.

Regular rebalancing helps manage portfolio risk and gives you the opportunity to revise your portfolio allocation should your risk tolerance or financial goals change.

When should you rebalance a portfolio?

Two of the more popular approaches to rebalancing are:

  • Rebalancing by time.
  • Rebalancing by percentage.

When you rebalance by time, you pick a date on the calendar for when you will rebalance. Many people choose to rebalance quarterly, and some employer retirement plans allow you to set up automatic rebalancing by date.

The downside to this approach is that your portfolio may not need to be rebalanced on the date you choose. In fact, your allocations could get out of alignment at any time between the date of your last rebalance and your next – potentially exposing you to unwanted risk.

Rebalancing by percentage helps eliminates this problem.

Rebalance a portfolio based on percentage

When you balance based upon percentage, you start by setting up what are known as “drift parameters” for each asset class, allocation thresholds that you don’t wish to exceed.

For example, you may decide that U.S. value stocks can make up as much as 28% of your portfolio or as little as 22%. If your allocation drifts past either of these thresholds, then it’s time to rebalance.

The advantages of this approach are twofold. You rebalance as soon as needed so that you may not be exposed to excess portfolio risk and you only rebalance when needed.

This second point is particularly important if you are rebalancing a portfolio outside of a retirement account because each time you sell an asset you are potentially exposed to tax liabilities if there are any realized gains, and both buying and selling of assets can incur fees and commissions.

The downside of rebalancing by percentage is that you have to watch your portfolio daily to make sure your asset alignment stays within your drift parameters. At Edelman Financial Engines, we eliminate that problem for our clients by constantly monitoring their portfolios and rebalancing them by percentage whenever needed.

Rebalancing in bear or bull markets

Another benefit of rebalancing is that it is responsive to the cyclical nature of the stock market and different asset classes. What this means is that as markets go through bullish and bearish cycles, some assets overperform while others underperform.

Rebalancing can help take advantage of this phenomenon.

For example, if bonds are up, you might sell some to bring your allocation back into balance, and you may need to buy some stocks that are down. In that way, you sell high (the bonds) to buy low (the stocks). And you would do the same regarding other asset classes. So when you rebalance, you sell some of the overperformers and buy some of the underperformers, which when done regularly, may result in better long-term returns.

Rebalancing is an important tool for maintaining your portfolio’s original asset allocation and keeping your risk profile in line with your overall tolerance, while at the same time offering flexibility to adjust your strategy should your goals or investing plans change.

 

Investing strategies, such as asset allocation, diversification or rebalancing, do not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Funds and ETFs are subject to risk, including loss of principal. All investments have inherent risks. There can be no assurance that the investment strategy proposed will obtain its goal. Past performance does not guarantee future results.

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