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Why It’s Important to Rebalance Your Portfolio Each Year
By Sean Condon, CFP®
Why you should rebalance your portfolio and how to do it correctly
We believe that rebalancing your portfolio should be done regularly. Although it may feel completely counter-intuitive, it can make or break your investing progress because it can help reduce portfolio risk and maintain your established asset allocation. But what does “rebalancing” mean?
It’s not complicated, though it may seem backwards at first. Rebalancing means selling some of your better performing investments and buying a bit of your laggards (“sell high” and “buy low”). The goal is to reestablish your target asset allocation. Here’s an example:
For simplicity’s sake, let’s say your desired asset allocation is 70% stocks and 30% bonds (this will vary based on your personal situation and the idea that your portfolio has been designed with purpose). As time goes on, stock prices rise, causing your allocation to shift to 80% stocks and 20% bonds. To rebalance your portfolio to 70/30, you’d have to sell some stocks and buy more bonds.
It sounds simple. But don’t be surprised if it still feels wrong.
Rebalancing Can Be Difficult to Execute
Intuitively it feels wrong to sell the best performing assets in our portfolio and buy more of the worst. After all, we’d make the opposite decision in almost any other area outside of investing. For example, if you own a business with two divisions and one is doing poorly while the other is thriving, it’s reasonable to consider terminating the underperforming unit and re-allocating resources to the successful one.
Investing is different. There’s an old saying that great companies make for great investments at great prices. Remember that the investment in your portfolio that has gone up in value has also gone up in price. It is, in effect, more expensive to buy (or hold on to). On the contrary, the investment that has gone down in value is now less expensive. It’s like an item that goes on sale and is now available at a discount.
Because markets tend to work in cycles, it’s likely that the underperforming assets may soon be back in favor as investors begin to feel that they are priced at a discount and provide good opportunity. This is the classic scenario of buy low, sell high.
Rebalancing Reduces Risk
So, while it’s tempting to double up on your winners, we know this isn’t always wise. Not only does it go against the fundamental reasoning of “buy low, sell high,” but it also adds risk. If one asset class starts to make up too much of your portfolio, it means you have too many eggs in one basket. If that asset class starts crashing, a sizeable chunk of your portfolio will fall with it.
This goes both ways. If an asset class performs poorly and starts to make up less of your portfolio, you now have too few eggs in one basket. If you fail to rebalance and this asset class starts doing well, you won’t be able to take full advantage of it.
If you never rebalance your portfolio, your allocation will gradually shift so you’re no longer invested according to your risk tolerance (either too aggressive or not aggressive enough).
A general recommendation is to rebalance every year. This is a good guide for most people, although the best method is to create a disciplined process to rebalance whenever an asset allocation changes by a predetermined percentage.
Rebalancing Allows For A Deep Inspection
Rebalancing is not only a time to balance asset allocation, but it’s also a time for balancing investments within each asset allocation.
For example, you may look at the small-cap stock funds and realize one fund has grown substantially more than the rest. When this happens, try to fight your natural reaction to buy more of this investment. If you follow the “buy low, sell high” philosophy, you would sell some of this high-performing fund to buy more promising underperforming funds. This way, you’ll decrease risk by not having one investment representing too much of an asset class, and potentially gain more upside on the undervalued asset.
It should be noted that rebalancing can potentially trigger tax consequences when done in taxable accounts (i.e., outside of IRAs or retirement plans). These potential tax issues should be considered in relation to the benefits of rebalancing. As always, check with your tax advisor.
It would be easy if creating your portfolio were a “set it and forget it” type of deal. Unfortunately, it shouldn’t be. Investment management requires regular maintenance and upkeep. If neglected, your performance will suffer. That’s why it’s a smart idea to work with a professional advisor who can keep an eye on it for you.
If you’re interested in learning how we at Windgate can help create and maintain your portfolio, feel free to get in touch. You can reach us by calling (844) 377-4963, emailing firstname.lastname@example.org, or booking an appointment online here.