Mastering Portfolio Rebalancing: A Step-by-Step Guide to Aligning Your Investments

Adjusting your investment portfolio

Adjust your investments with these four straightforward steps.

Key Takeaways

• Rebalancing involves aligning your portfolio with your intended asset allocation.

• Rebalancing may be required if your portfolio has deviated from its course or if there have been changes to your targeted asset allocation.

• This process often entails selling portions of investments that are disproportionately large and purchasing more of those that are underrepresented.

• It is crucial to consider the potential tax implications of rebalancing within a taxable account.

Rebalancing is an essential aspect of managing your investments over time.

If investing is akin to purchasing a car—requiring initial time, research, and significant decisions—then rebalancing is comparable to regular vehicle maintenance. Although it requires some effort, it ensures that everything operates smoothly and that you reach your financial goals.

What is Rebalancing?

Rebalancing is the strategic process of buying and selling investments to ensure they stay aligned with your investment strategy.

When you first started investing, you probably set a specific asset allocation target, such as a 50% allocation to stocks. As time passes and investment prices fluctuate with different rates of return, your actual allocation might drift from your original target. Rebalancing involves aligning your portfolio with your targeted allocation by trimming positions that have exceeded their intended size and increasing those that have diminished.

Why is rebalancing essential?

Rebalancing is crucial for keeping you aligned with your investing goals. In a well-structured portfolio, each investment plays a specific role. Ensuring your investments remain balanced is key to maintaining the performance you expect from your portfolio.

Specifically, rebalancing can:

Manage risk

At times, higher-risk investments may outperform lower-risk ones. However, if these higher-risk investments increase as a percentage of your portfolio, the overall risk level rises. Rebalancing effectively realigns your risk exposure.

Maintain returns potential

In other instances, lower-risk investments might excel, especially during downturns, increasing their share of your portfolio. While it’s comforting to hold low-risk investments, they typically yield lower returns over time. Rebalancing by reducing lower-risk investments and boosting higher-risk ones ensures your potential returns remain on target.

Stay diversified

As your asset allocation shifts over time, certain portfolio positions may become overly dominant. Rebalancing restores diversification, ensuring risks and potential returns are effectively distributed across your investments.

How to Rebalance

Outlined below are the essential steps for rebalancing.

Step 1: Determine Your Portfolio’s Current Asset Allocation

This involves assessing the percentage composition of your portfolio across various major asset classes, such as U.S. stocks, international stocks, bonds, and short-term cash-like investments. Some investors may also choose to analyze more detailed categories, such as allocations to large companies versus small companies.

Step 2: Compare with Your Targeted Asset Allocation

Align your actual asset allocation with your targeted asset allocation and identify categories that exceed or fall short of your targets.

If you haven’t established a targeted asset allocation yet, now is the perfect time to do so. Begin by learning more about investing basics, exploring model portfolios designed for various risk tolerance levels, or examining sample asset allocations.

Step 3: Determine the exact amount to buy or sell for each position

Sell a portion of investments that have grown excessively as a percentage of your portfolio and increase investments that have diminished. If you're planning to contribute more to your investments soon, consider using those contributions to rebalance. This strategy can help you achieve your target allocations by purchasing more of the positions that have decreased, without needing to sell any.

Step 4: Execute Trades to Rebalance

In the final step, confidently place the trades necessary to align your portfolio’s actual asset allocation with your targeted allocation.

Remember, depending on your portfolio's cash position, you may need to execute “sell” trades first to generate the cash required for your “buy” trades.

Can Rebalancing Trigger a Tax Bill?

Tax implications from rebalancing depend on the type of account you're using.

Rebalancing in tax-advantaged accounts incurs no tax consequences. These include 401(k)s, Roth and traditional IRAs, health savings accounts (HSAs), and 529 accounts.

However, rebalancing in a brokerage account can lead to tax consequences if you sell part of a position. Selling an investment at a profit creates a capital gain, which is generally taxable. Conversely, selling at a loss results in a capital loss, which can potentially offset capital gains or income, effectively reducing your taxes.

As noted, using new contributions for rebalancing might realign your portfolio without selling positions, helping to avoid tax triggers in a brokerage account.

How Often Should You Rebalance?

There are three main strategies for determining when to rebalance:

• Calendar Approach. Rebalance on a fixed schedule, like annually.

• Threshold Approach. Rebalance when your asset allocation deviates by a specific amount, such as 5 percentage points or more from your target.

• Hybrid Approach. Regularly evaluate your portfolio, such as quarterly, but only rebalance if allocations have deviated by a certain amount.

While maintaining your portfolio is essential, avoid excessive tinkering. Over-monitoring can lead to frequent trades or reactive decisions. Frequent rebalancing can incur unnecessary costs in taxable accounts or if transaction fees apply.

Adopt a balanced rebalancing strategy that keeps allocations on track while being mindful of taxes, fees, and your mental bandwidth.

Get Help with Rebalancing

Rebalancing is straightforward in theory but can become complex in taxable accounts. Additionally, some investors may find executing trades stressful due to fear of mistakes or lack of confidence.

Fortunately, investment options can relieve you of rebalancing duties. These include all-in-one mutual funds, like target date funds, or professional management through a robo advisor or a dedicated financial professional.

If you need more assistance and are uncertain about the next step, consider how we can work together, or take a quiz to find the managed account that best suits your needs and goals.

Best Regards,

Stock Market Charlie aka The Hound of 317