With different parts of an investment portfolio performing at different levels, a periodic review of your investments is needed to determine if your portfolio is still allocated in the percentages you originally wanted.
If the pieces of your investment portfolio pie aren’t divided the way you want, you need to rebalance your portfolio.
What is Rebalancing?
Rebalancing is a periodic re-shifting of a portfolio’s assets to put the holdings into a desired allocation. Let’s look at a simple example. An investor has $100,000 and puts 50% in stocks and 50% in U.S. Treasury bonds. Usually an investment portfolio is more diversified than this, but let’s keep it simple.
At the end of the year, the stocks may have risen 12% in value or $6,000 while the bonds might have increased 3% or $1,500. The total portfolio is now worth $107,500, but the asset allocation is no longer 50/50 — it’s about 52% stocks to 48% bonds.
The trouble with that is if the stocks tank as the stock market drops, a greater percentage of the portfolio’s value drops. That’s where re-balancing comes in.
The investor will want to sell off 2% of the stock value and reinvest that money into the bonds to make the portfolio 50/50 again.
How Often Should You Rebalance?
Rebalance the portfolio at least once a year. The investing proof is in the results. Paula Pant of Business Insider gave an example of two model portfolios of $10,000 each that were tracked by Forbes for 25 years. Each portfolio was split 60% stocks and 40% bonds — one was rebalanced each year, the other was not.
At the end of the 25 years, the rebalanced investment portfolio was $97,000 and the other was $87,000.
Some financial advisers recommend adding rebalancing to the end-of-year financial review of investments for tax purposes.
“It is especially important for those of us who are retired or near retirement to examine our investment and make sure we are on the right track for our short term as well as longer term goals,” wrote Regard Solution Strategies on Seeking Alpha.
Rebalance To Lower Risk
When faced with corrections in a bear market, rebalancing is a way to safeguard your portfolio from possible steep losses — called a market timing technique.
“The market timing techniques that I favor the most involve tracking the S&P 500 current year earning and looking for upward or downward trends,” wrote Seeking Alpha contributor Aggressive Dividends. “When estimates are rapidly slashed, a downturn is often right around the corner (or it recently began). The same is true when earnings are sharply revised upwards.”
Don’t Forget About Taxes
When an investment portfolio is rebalanced, especially if the investor wants to sell off stocks, there are tax considerations that come into play, namely capital gains tax. It might be better to keep the allocations the way they are to avoid the capital gains tax.
Practice rebalancing your portfolio on our simulator and learn to adjust it to market conditions for the biggest gains.