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What is Portfolio Rebalancing? Plus, the Top 4 Benefits Thumbnail

What is Portfolio Rebalancing? Plus, the Top 4 Benefits

Investing Retirement

As markets go up and down, the assets in your accounts will grow at different rates. This will cause your overall portfolio to veer away from your target asset allocation.

Rebalancing involves reallocating funds from the fast-growing assets into slower-growing assets.  It is important in retirement to not stray too far from your asset allocation. Your asset allocation is your blend of stocks, bonds, and cash and is set based on your risk tolerance and time horizon. Read on to find out what portfolio rebalancing is and why it is important. 

 What you will learn:

  • What is Portfolio Rebalancing?
  • Portfolio Rebalancing Strategies
  • Benefits of portfolio rebalancing
  • Costs to consider when rebalancing

WHAT IS PORTFOLIO REBALANCING?

Portfolio rebalancing is the process of restoring investment accounts to their target asset allocation.  At the highest level, an asset allocation is your mix of equity (stocks), real estate, fixed income (bonds), and cash in your account.

An investor’s target asset allocation varies according to his or her time horizon and risk tolerance. Time horizon is how long until the money needs to be used. In retirement, you should have short-term, mid-term, and long-term buckets of money. Most retirees should have 12 months of spending needs in cash within their portfolio, followed by 2-5 years of spending needs in bonds.  The remaining funds should be allocated to stocks for higher growth. 

Risk tolerance refers to how much volatility an individual is willing to accept while investing. A person who is not willing to stay the course during market turbulence should be invested with a larger allocation to cash and bonds. Retirees and people who are depending on their portfolios for regular spending should also be slanted towards a more moderate portfolio.

A portfolio for a moderate investor or retiree who needs regular income from the portfolio might consist of 65% equity, 30% fixed income, and 5% cash. While an investor who has a long-time horizon for needing funds and/or who is willing to take more risk, might have an allocation of 85% equity, 10% fixed income, and 5% cash.   Asset allocation is a case-by-case situation and personal to each investor.

A portfolio is rebalanced by buying or selling assets to maintain the desired asset allocation in a portfolio. Investors with a predetermined level of risk exposure sometimes seek professional portfolio management services to keep their portfolios in-line with their needs. The portfolio manager will adjust the holdings according to the client's constraints and preferences. 

If your investment strategy or risk tolerance has changed, you can also adjust the weightings of your asset classes during portfolio rebalancing. For example, as people get closer to retirement they often shift more of their assets to bonds and cash than what they once had. 

PORTFOLIO REBALANCING STRATEGIES

There are different methodologies for rebalancing portfolios. The difference between most of them lies in when rebalancing should occur. Many retirees find one rebalance each year sufficient. However, others choose to rebalance quarterly or semi-annually, depending on the market volatility. 

CALENDAR REBALANCING

Calendar rebalancing is a basic rebalancing strategy and the most common. It involves analyzing the portfolio's investment assets at predetermined time intervals and restoring them to the desired allocation as required. Many investors choose quarterly or semi-annual rebalancing.

 If you adopt calendar rebalancing, you can decide your rebalancing frequency according to allowable drift, time constraints, and costs. The number of times you rebalance could even vary from year to year. You may even choose to rebalance earlier than planned if the market has had an exceptionally good or bad year.

PERCENTAGE-OF-PORTFOLIO REBALANCING

Percentage-of-portfolio rebalancing is a slightly more intensive and expensive approach that focuses on the allowable tolerance for being outside of set asset allocation guidelines. The investor rebalances the portfolio each time an asset class falls outside of a set range.

For example, an investor’s portfolio management strategy might require it to hold 40% in domestic equities, 30% in bonds, and the rest in emerging market equities with a +/- 10% tolerance for each asset class. This means the asset classes are allowed to fluctuate 10% higher or lower from the set range before being rebalanced. When an asset is outside of this range, the investor must rebalance the portfolio to the original target allocation.

Asset classes with high market volatility can require a narrower tolerance to avoid over-representation or under-presentation in the portfolio. Assets and asset classes strongly correlated to other investments can have broader tolerances since their price moves parallel with other assets in the portfolio.

Things to consider when determining your tolerance for being slightly out of balance are:

  • Transaction costs
  • Market volatility
  • Correlation with other portfolio assets 

AUTOMATIC REBALANCING

Advanced technology has given us automatic rebalancing. Automatic rebalancing uses technology to check an investor's portfolio balance regularly. If the portfolio is out of balance the computer system automatically buys or sales assets to restore the portfolio to the original asset allocation. This method does not require much intervention on the part of the investor or portfolio manager.

 Automatic rebalancing applies the percentage-of-portfolio method. Automatic rebalancing can potentially lead to high transactional costs or investment management fees due to the more frequent trading, technology costs, and the portfolio manager oversight of the systems.

TOP 4 BENEFITS OF PORTFOLIO REBALANCING

1.   MAINTAINING PORTFOLIO ASSET ALLOCATION AND RISK EXPOSURE

Portfolio rebalancing aims to return an account to a specific asset allocation. Portfolio asset allocation involves purchasing different asset classes at set amounts to create a portfolio. Different classes of assets offer different return rates and are volatile in different ways. Asset classes are equity (stocks), fixed income (bonds), cash, and real estate. An account that is over allocated towards one asset or asset class can increase the entire portfolio’s risk beyond what an investor is willing to tolerate.

2.   PORTFOLIO REBALANCING ENFORCES A LEVEL OF DISCIPLINE

The decision to sell a portion of your winning assets and put the money into an underperforming asset may not sit well with emotional investors. Portfolio rebalancing enforces a certain level of investment discipline, saving investors from their worst instincts.

Letting your winning asset classes run when the market is going up is tempting. However, no one knows what the market will do tomorrow. Being overallocated to one asset or asset class adds additional risk to your portfolio.

3.   AN EXCELLENT TIME TO REVIEW YOUR PORTFOLIO

Portfolio rebalancing offers investors an opportunity to review their holdings and strategy. It is also a good time to reevaluate your risk appetite.

Some things to take into consideration when reviewing your portfolio are:

  • Have your fund expense ratios changed?
  • Are your mutual funds and/or ETFs close to their given benchmark if they are index funds? If they are active, are they performing how you expected?
  • Is your account still in line with your asset allocation you set out to have?
  • Do you have a high concentration in one stock?
  • How much and when will you take distributions out of the portfolio? What is your time horizon?

4.    PORTFOLIO REBALANCING HELPS YOU STAY ON TRACK WITH YOUR FINANCIAL PLAN

Portfolio rebalancing can help you maintain your investment strategy. A portfolio investment strategy should tie your target asset allocation to your financial goals, risk tolerance, and time horizon. The portfolio rebalancing process gives you a set time to review the factors that play into your portfolio investment strategy.

COSTS TO CONSIDER WHILE REBALANCING A PORTFOLIO

There are two types of costs to consider when rebalancing your portfolio:

  • Transactional costs
  • Taxes

Transactional Costs

You may incur transactional fees and commissions when rebalancing your portfolio. Some of these are the typical buying and selling fees that are charged when assets are sold or bought. Another source of potential fees is from mutual funds that have redemption fees or sales charges known as loads.

Some investors work with advisors who derive compensation from their commissions. Many such investors do not understand the impact of such arrangements until their next portfolio rebalancing. You can avoid such unexpected costs by working with a fee-only CERTIFIED FINANCIAL PLANNER™ who doesn’t work for a commission.

Taxes

Portfolio rebalancing can also trigger taxable capital gains if they occur in a taxable investment account. A capital gain occurs when you sell an asset for more than what you paid for it. A financial planner can help you determine which assets would be subject to capital gains taxes if they were sold.

You should also know that while you may not like paying taxes, it could be cheaper to pay some extra taxes on capital gains today to avoid larger losses from an unbalanced portfolio in the future. 

CONCLUSION

Portfolio rebalancing, especially in retirement, is very important. It helps maintain your asset allocation and risk exposure. Rebalancing is also a source of investment discipline since keeping a balanced portfolio can help you avoid trading on emotions. 

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