Most investors use asset allocation as a core investing strategy. This means investing a specific amount in each investment, which could be viewed as slices in a pie. At the high level, these pies are different asset classes like equities, fixed income, real estate, commodities, and cash. Within each pie, an investor also decides a specific amount to invest in each investment. Naturally, these different investments will gain or lose value at different rates causing your well-crafted portfolio to drift away from its original asset allocation. What should you do when this happens? The answer is portfolio rebalancing.
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Portfolio Rebalancing Examples
For example, you might decide that the best asset allocation for your needs is to have 60% equities, 20% fixed-income, 12% real estate, 5% commodities, and 3% cash. After a while, your portfolio drifts away from the original percentages. After a certain amount of drift, or time period, you decide to rebalance your portfolio and put everything back to its original percentages.
Asset Allocation Adjustment
Another example is when you intentionally try to change the risk-reward profile of your portfolio. Maybe you decide that having 60% equities is no longer the right mix, and you want to lower it to 55% and increase fixed-income to 25%.
In this case, you will also need to rebalance your portfolio.
Portfolio Rebalancing Advantages
Disciplined Method to Buy Low and Sell High
When you sell some of your winners and buying more losers, you are following a disciplined process to buy low and sell high.
Assuming you have a good mix of investments with low or negative correlation, your losers will eventually become winners and vice versa. Over the long-term, things will balance out, and the strategy helps you periodically buy low and sell high — which is a good thing!
While it is nice to have a large equities allocation during a bull market, it is not a good feeling to see a crash wipes out half of your gains. By regularly rebalancing your portfolio, you are systematically sticking to your long-term investment plan. At the same time, you are mitigating the risk of your winners taking a sudden loss.
Portfolio Rebalancing Disadvantages
On the flip side, it is possible that while you are selling a little bit of the winners and buying a little more of the losers, those investments continue to move in the same direction. This means that you are losing out on some of the gains if you had kept your full position in the winners, and take on some extra losses by buying more of the losers.
That said, you can’t time the market, and the best investment policy is to have a plan and stick to it. This small disadvantage should not discourage you from staying disciplined.
Taxes and Fees
Depending on your investment accounts and the brokers you’re working with, rebalancing could create taxable events and cost you money in trading fees.
For example, rebalancing in my taxable account with TD Ameritrade (or any broker that charges a trading fee) will result in a $6.95 trading fee for each trade, and I would be on the hook to pay capital gains taxes on any realized gains. Also, be on the lookout for 401(k), some plan charges an extra fee for rebalancing your portfolio.
On the other hand, rebalancing in a retirement account using a free broker (like M1 Finance) doesn’t cost any money.
Two Methods to Rebalance a Portfolio
There are two main ways to rebalance your portfolio: full rebalancing and incremental rebalancing.
Full rebalancing is the nuclear option. You basically sell enough shares of the winners to bring their percentages down to the right amount and use the cash to buy shares of the losers to bring their percentages up to the correct amount.
In a large portfolio, this is often your only choice because incremental changes are not sufficient to correct the drift. However, it does generate capital gains which could be subject to taxes in taxable accounts.
This method is suitable for smaller portfolios. As you add new money into your portfolio, e.g., with your 401(k) contributions or with dividend reinvestment, you can focus on buying underweighted investments. For example, if your fixed-income allocation has drifted down, you could buy more fixed-income investments with new deposits and dividend payments.
The one thing I love about M1 Finance is that it does this incremental rebalancing automatically.
For a retiree that is actively withdrawing from the retirement accounts, withdrawals could be made primarily from equities allocation to help lower equities exposure as the investor ages.
How Often Should You Rebalance?
You can decide how often to rebalance your portfolio, based on your own personal style and your investment plan. It’s important not to get too caught up in rebalancing, though. You don’t want to be changing up your portfolio every month. Rebalancing starts to lose some of its usefulness if you decide to rebalance more than four times a year.
Time-Based: Periodic Rebalancing
Many people choose to rebalance once or twice a year, and others prefer to rebalance quarterly. Doing it on a regular periodic basis is a good way to stay disciplined. You can set up a reminder on your calendar app along with other important financial tasks, and time to line up with important financial events, e.g., tax dates, tax-loss harvesting deadline, RMD deadline, account contribution deadlines, etc.
Asset-Based: 5/25 Rule for Portfolio Rebalancing
Another method of deciding when to balance is to rebalance when your asset allocation gets off base by more than 5%. From his book Think, Act, and Invest Like Warren Buffett, Larry Swedroe suggests that an investor should rebalance the portfolio whenever the allocation changed by an absolute amount of 5% (e.g., from 40% to 45%) or by a relative amount of 25% (e.g., from 6% to 4.5%).
For example, any of these situations would trigger a rebalancing:
- A 35% allocation drops below 30%
- A 40% allocation increased above 45%
- A 5% allocation dropped below 3.75%
- A 10% allocation increased above 12.5%
Portfolio Rebalancing Pro Tip
Typical investors have multiple investment accounts, for example, Roth IRA, 401(k), and a taxable account. These accounts can be categorized into three buckets, aka Asset Location.
If your account balances allow it, you could set up an IRA with a free broker as the main hub for your asset allocation and rebalancing activities. This way, you could rebalance your portfolio without paying any capital gains taxes or transaction fees.
- In our 401(k) plans we invest in one U.S. Broad Market Fund in one plan and one Target Date Fund in another plan. This keeps our investment expenses low since these are the lowest expense fund for each plan.
- In our Roth accounts, we hold various long-term high growth investments.
- In our Traditional IRA, we invest in various investments that help us meet our asset allocation plan. Since this account is invested with M1 Finance, we can do fine-tuning and adjustments without incurring any fees or taxes.
Rebalancing is an important activity to help restore your portfolio target allocation. In the long-term, it should help you reduce risk and enhance portfolio performance.
Taxes and fees are important considerations when rebalancing. However, you can almost entirely eliminate these expenses by having the right asset location that aligns with your asset allocation, and set up a tax-advantaged account with a free broker where you perform the majority of your rebalancing activities.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
I agree with the statements above. I do re-balancing every year during spring cleaning. One of the big things for me is to clean out my bank stock. I work for a bank and some of their 401k match is in company stock. All the banks did awfully last year. I also has a fund holding some bonds that outpaced my stock indexes, so a rebalance is in order. Some will recommend rebalancing every 6 months, but I think annually is perfectly fine. Great post!
Hello, Pinyo, I thankfully went through the process of rebalacing my portfolio at the beginning of the year. On the one hand, it was sad to see lower balances, but on the other hand, it was good to feel secure as I head into another year of investing. It’s good to keep buying when blood is running in the streets, as some famous investor once said. In other words, keep investing, especially when fear is rampant, because that is the best time to pick up low deals on equities.
@Steve – I hope things start to pick up soon. It is rather slippery on Wall Street at this point.