If you’re like a lot of adults, you have investments in a variety of places. You might have a retirement fund from your employer, maybe some older ones from previous jobs, and possibly a CD or two.
Whether retirement is knocking hard at your door, or it’s still decades away, you need a strategy to prepare for it. Your investments are intended to help you grow your assets while you earn an income, so you have a predictable way to support yourself and your loved ones in the future.
To do this, you’ll need an asset allocation strategy that balances growth and stability, so that you aren’t constantly worrying about losing money or agonizing over how little your investments are growing. Once you reach that spot, you have to rebalance it on occasion. Here are a few things you should know before you start researching a plan.
What Is Portfolio Rebalancing and Why Is It Important for Long-Term Investors?
When you start to seriously invest in your financial future, you’ll need to choose where to put your assets. You make this decision based on your financial goals, risk appetite, and more. After you create a plan for asset allocation, usually based on a percentage of the value of your investments, you may need to periodically rebalance your assets to support your plans.
The reason for balancing is that every type of asset has a different rate of risk and reward. Once you figure out your risk tolerance, in terms of your emotional comfort with variability, as well as your financial plans, you’ll want to maintain that balance. Market performance can sometimes throw off the target percentages, which may require you to shift your assets slightly to accommodate. You may also need to rebalance your portfolio as you get older and shift into wealth preservation more than growth.
Although not every investment has guaranteed returns, a balanced portfolio helps to ensure that you get the kind of growth you need without exposing you to more risk than you can handle. It also helps you maintain broad consistency and discipline in your investments without requiring you to make snap judgments based on market timing. That way, as you approach or move further into retirement, you can continue to meet your goals for wealth preservation and long-term financial planning.
How Do You Determine the Right Asset Allocation for Your Portfolio?
Before you can figure out how to rebalance your portfolio, you’ll need to create a plan for asset allocation. Asset allocation isn’t a one-size-fits-all strategy, so you’ll need to tailor yours based on your risk tolerance, time horizon, and expectations from the portfolio. Common asset types include:
- Equities, commonly known as stocks
- Fixed income investments, such as government bonds or certificates of deposit (CDs)
- Cash in a savings vehicle that is easy to access but may not provide a high growth rate
- Alternative assets, like private equity or real estate
Most people will have their investments spread out across at least a couple of these. You might hold shares in multiple stocks or buy different types of bonds from separate entities. The goal is to spread out the risk and target a specific growth rate.
The right asset allocation changes as you do. When you get older, you may want to decrease the risk of your portfolio to mitigate big, unexpected losses. If you plan to cash out the investment within five years, your plans for growth will be different than if you’re willing to let it sit for decades.
When you plan out your asset allocation*, the goal is to get a “just right” balance between growth and stability. If you put too much money into high risk/high reward investments, you may face bigger losses during a downturn. But if you put too much into fixed-income assets, your investments may not grow fast enough to support you in retirement. Whenever you see that the portfolio is starting to move too much in one direction, it may be time to rebalance it.
How Can You Tell When Your Portfolio Needs Rebalancing?
If you never look at your portfolio, you may not know when it’s time to rebalance**. Even if you don’t consider yourself an investment expert, there are a few ways you can tell that your asset allocation needs review:
- The growth of one asset class has changed significantly from what your plan anticipated
- You’ve had a major life event that changes your financial picture, such as retirement, sale of a business, or a major inheritance
- Your risk tolerance has altered, due to life changes or simply getting older
Ideally, your asset allocation focuses on a percentage of the portfolio instead of specific dollar values. If you want to maintain the appropriate balance, you’ll need to review the portfolio at least once or twice a year. Keep in mind that this type of monitoring doesn’t mean you have to change anything. Constantly tweaking your investments can increase fees that cut into your gains and create emotional instability. Adjustments should be deliberate and future-focused, not based on last week’s market performance.
When Is the Best Time to Rebalance Your Portfolio?
The right time to rebalance your portfolio depends on how long you’re planning to keep the investments and your general tolerance for change. There are several approaches you can take, but you’re more likely to rely on a calendar-based or threshold-based rebalancing plan.
Calendar rebalancing has you and your financial advisor looking at the portfolio at a set time, usually once a year. This approach has the benefit of helping you monitor performance regularly, without having to watch every dollar go in or out. But if there is a major shift in your asset values, you may not move quickly enough to counteract it.
Threshold rebalancing allows you to keep your asset allocation as it is until you reach a certain threshold, such as a 5% deviation from your current strategy. This approach is ideal for people who want to be able to make changes when there are significant movements in the market, but it can also train you to watch the markets constantly to anticipate a triggering event.
Ideally, you’ll focus on consistency instead of exact precision and avoid reactive decisions when the market is making regular adjustments. Rebalancing should always support your long-term financial strategies, rather than whatever the exchanges are doing at a particular moment.
How Can You Rebalance Your Portfolio in a Tax-Efficient Way?
There are a lot of tax laws concerning how you handle your investments, so it’s wise to rebalance your portfolio with a tax strategy. Most retirement funds have tax advantages, meaning that you may not have to pay taxes when you make withdrawals under certain conditions or be able to defer paying taxes until you make those withdrawals.
Your other investments are probably taxable, though. You pay taxes on dividends and interest accumulated, but it doesn’t end there. When you pull money out of an investment to rebalance your portfolio, you may need to pay taxes on the gains in value from the original price. Tax rate depends on how long you held the asset and your other taxable income.
For many people, rebalancing using tax-advantaged retirement accounts can minimize tax burden and exposure to capital gains taxation. In many cases, you can roll retirement investments into other tax-advantaged vehicles without increasing your capital gains exposure that year.
In any case, it’s important to align your rebalancing with your tax planning. Be aware of your tax situation, especially if you are a high earner or have income approaching the next bracket. That way, you can work to improve your asset allocation without putting yourself at risk for a big, unexpected tax bill next year.
How Should You Monitor and Adjust Your Portfolio Over Time?
Even if you figure out the ideal asset allocation for your investment portfolio, you should know that it will change over time. Asset allocation is an ongoing discipline, not a single box to be checked.
You’ll want to change your asset allocation as your life progresses, such as a sudden change in income, an update to your risk tolerance, or a new financial goal. Most people become less risk-tolerant once they move into retirement, increasing the allocation to assets that are more predictable and less likely to lose money.
Although a lot about your asset allocation strategy depends on your needs and market performance, there are other factors to consider. Changes to tax laws may open up new opportunities that are worth considering or require you to re-evaluate your tax strategy for your investments.
For better results, it’s important to keep the balance in line with your long-term objectives. Changes to your asset allocation should be slight and gradual for routine rebalancing. Take a look at it at least once a year, but you may not always need to make adjustments.
What Common Mistakes Should Investors Avoid When Rebalancing?
Rebalancing your portfolio, while a necessary task, can introduce the possibility of errors. Mistakes can hurt the performance of your portfolio, increase the fees you have to pay, or affect your tax liability. Do your best to avoid these common problems:
- Making sudden changes to try to get in on a recent upswing, putting you at risk for buying at the peak
- Pulling investments reactively during a downturn, which can increase your capital gains taxes and decrease your opportunities for long-term growth
- Frequent rebalancing, which increases your fees and can affect your emotional comfort with regular market performance
- Rebalancing once and then avoiding changes later, even when circumstances call for it
- Ignoring the tax consequences of your rebalancing strategy, which can put you at risk for high tax bills or penalties
Ultimately, you should aim for discipline and consistency. This approach doesn’t mean that you never make changes, but that the adjustments are intentional and fit with your long-term financial goals.
Should You Rebalance Your Portfolio on Your Own or Work With a Financial Advisor?
As you may guess, adjusting your portfolio to work with your financial situation and retirement goals isn’t easy. Once you start putting money into a variety of investments within each asset class, you increase the overall complexity.
Taking money from one asset and putting it into another can change the overall risk and growth of the entire portfolio. That’s not even considering the complications that portfolio rebalancing can present for your tax, estate, and income planning.
Working with a professional advisor can give you a number of benefits. Financial advisors who are fiduciaries have a legal and ethical responsibility to make the best decisions for you. They have objectivity, which means that they are less likely to be emotionally triggered by how market volatility affects your portfolio. That way, they can help you stay disciplined and working toward your goals.
A financial advisor’s experience can ensure that your portfolio aligns with your financial situation and broader wealth management goals.
How Rebalancing Fits Into a Long-Term Wealth Strategy
Having a plan for your investments is a great advantage, but you’ll need to take steps to ensure that your portfolio works for you as you need it to. That’s where portfolio rebalancing comes in, by keeping your asset allocation at levels that align with your life stage, retirement plans, and risk appetite. It’s a useful tool to manage risk, not a tactic to game performance. The ideal rebalancing strategy aligns with:
Striking the right balance with your portfolio requires discipline and consistency. That way, you continue to work toward your goals, without making snap judgments that may or may not improve current performance at the cost of long-term growth and stability. You should review your portfolio at least annually, but be ready to make no changes when it is not necessary.
At Brown and Company, we specialize in portfolio management, including routine rebalancing. We act as a long-term partner in your wealth management and retirement planning. To learn more about our services, contact us for more information.
*Asset allocation does not ensure a profit or protect against a loss
**Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.