Rebalancing involves selling some investments and buying others with the aim of returning your portfolio back into line with its strategic asset allocation. Frequent trading, however, can increase costs and decrease returns.
Rebalancing is particularly essential for investors with tax-advantaged retirement accounts like an IRA or 401(k), since selling within these accounts does not incur short or long-term capital gains taxes.
Asset Allocation
Rebalancing is the practice of returning your assets back to their initial allocation target in each category, such as stocks or bonds. Your initial asset allocation goal might have been for stock investments to represent 70% and bonds 30% respectively of your portfolio; over time due to market performance or other influences this might have changed; for instance, you might now own 76% stocks and 24% bonds instead. To rebalance, sell stocks in order to purchase investments underweighted asset categories in order to restore original allocation targets.
Rebalancing is one of the key benefits of portfolio rebalancing, helping to minimize the risk of having one investment dominate your overall performance. This can be especially important if your goals or time horizon change over time.
Many financial experts advise rebalancing on a regular schedule, such as once every six or twelve months. Some investors may choose to do it more frequently or use their judgment when markets become imbalanced.
Risk Management
Rebalancing can help ensure that you achieve your target asset allocation by keeping the risk levels of your portfolio in line with your risk tolerance. Without regular rebalancing, investments may drift away from their original target allocation over time and risk rising over time as a result of this shift, leading to higher risks and potentially lower long-term returns.
Rebalancing can reduce this risk by periodically selling off assets that have grown too large and buying underperforming assets to ensure your portfolio’s weighting remains within its target limits.
One popular method for rebalancing is threshold-based rebalancing, which involves reviewing your portfolio at regular intervals but only making adjustments if it falls outside a predetermined percentage from its target allocation. This approach can provide greater flexibility while potentially lowering transaction costs in taxable accounts; in addition, this strategy may help eliminate emotional decision making during market fluctuations by eliminating short-term fluctuations without having to react immediately.
Taxes
Rebalancing involves selling securities to purchase new ones, which may incur capital gains taxes for assets held for over one year and brokerage fees.
As your portfolio expands, its investments may fluctuate in value over time and cause your asset allocation to move away from its target, potentially increasing risk and impeding your efforts to meet financial goals.
Rebalancing periodically can help mitigate risks in your portfolio, though too frequent rebalancing could hinder potential momentum for certain stocks and incur unnecessary taxes in your taxable account. On the other hand, waiting too long can cause your portfolio to drift from its target asset allocation and expose you to higher levels of risk than necessary. Managing household-level rebalancing accounts that take into account various tax ramifications will optimize after-tax returns for maximum returns.
Time Frame
Rebalancing your portfolio depends heavily on the goals and time horizon of its investors. Investors with shorter-term goals may rebalance more frequently, while long-term holders might rebalance less often.
Rebalancing can be especially important for people who receive unexpected windfalls or inheritance, since investing their newfound cash quickly may become necessary. Also, major life events like marriage, retirement or the birth of a child often serve as triggers to revisit financial plans and adjust assets as necessary.
Rebalancing can help protect you from making investing mistakes that put undue risk into your portfolio and allow you to remain focused on long-term financial goals rather than day-to-day market fluctuations. When rebalancing, selling certain investments and purchasing others to bring back into line with their original asset allocation target; any profits realized will require taxes be paid – often less costly than purchasing new investments although financial professionals should always be consulted before selling or buying investments themselves.
