What’s Portfolio Rebalancing – And How Does It Affect You?

What’s “portfolio rebalancing” – and how can this strategy help you?

Rebalancing is one of the most critical components of a smart long-term portfolio strategy. It describes a tactic to help you keep your portfolio aligned with your financial goals, your hoped-for returns and your risk tolerance.

However, not everyone understands portfolio rebalancing. Even within the investment industry, the term is often used incorrectly.

So let’s start by defining rebalancing, and then let’s talk about some ideas you should consider for incorporating this virtuous habit into your investment planning process.

Buy the Losers, Sell the Winners

If you think of your whole portfolio as a pie, then each “slice” of the pie represents a distinct asset class. The size of each slice depends on the goals, return requirements and risk tolerance we mentioned above.

Over time these slices, left to their own devices, will grow or decrease as different asset classes rise or fall in value. To bring your portfolio back in line with your asset allocation, you periodically need to sell off some of the winners – i.e. the assets that have done relatively better than others – and at the same time add to some of your holdings in the categories that did poorly.

It sounds counterintuitive, but over time the discipline is likely to pay off and keep your exposures from reaching inappropriate levels for your risk/return goals.

When Should You Rebalance?

There is no hard and fast rule for when, or how often, you should rebalance. But there are some useful rules of thumb.

First, if nothing else has triggered a rebalancing event (we will talk about these below) over the past twelve months, it’s most likely a good idea to rebalance on an annual basis at minimum.

Rebalancing is intended to keep a lid on how far the market value of each asset class in your portfolio varies from its target weight. It’s advisable to rebalance after a particularly volatile quarter; for example, if your U.S. large cap allocation were to shoot up from 15% to 20% in three months, you may want to bring it back in line.

Rebalancing Events

You could make rebalancing a calendar habit. You could rebalance in response to an unusually large intermediate-term deviation from target weights.

Or you could rebalance as a result of events that impact your profile as an investor, and change the nature of your portfolio in a meaningful way. We’ll look at both of these.

#1: Your Investor Profile

Changes in your own life will, from time to time, require you to rethink your investment strategy. Major life events like marriage, divorce or children fall into this category. Also, changes in your income level (or that of your spouse or partner) may necessitate revisiting and then rebalancing to a more appropriate asset allocation.

It’s also possible that your attitude towards risk may change, perhaps due to a life-altering event you experience. You may delay (or accelerate) your expected retirement age. Or you may change your approach to investing (for example, if you decide to stop paying fees for actively managed mutual funds and switch to ETFs.) Any of these events might trigger you to rebalance.

#2: Your Portfolio Situation

Routine things happen to your portfolio along the way. You may add, drop, or combine accounts. Perhaps you get a windfall lump sum of cash from an annual bonus or an inheritance. You may switch funds from a taxable to a qualified account like an IRA, 401(k) or 529 plan.

This last one is really important, because tax considerations do play a role in asset allocation decisions. Other tax triggers, like a change in cost basis, may be a catalyst for rebalancing.

Rebalancing and Glide Paths are Different

If you have started to plan for retirement, you may be familiar with the term “glide path.” It is important to note that a glide path and a portfolio rebalancing strategy are two different things.

“Glide path” refers to the natural progression over time from a higher proportion of growth-oriented assets, like equities and commodities, to more income-oriented exposures like fixed income, preferred stock or convertible bonds. Of course, this will also change the composition of your asset class weights, but conceptually it is a different activity.

Where to Find Help

If all this sounds overwhelming, don’t worry – there are resources available to help you make portfolio rebalancing strategies a regular and manageable part of your investment planning practice.

Jemstep’s Portfolio Manager service helps you identify when it is time to rebalance, whether it’s because of asset class drift from target weights or due to a change in your profile or your portfolio situation. It also offers specific, unbiased buy-and-sell recommendations to help you rebalance.

Making rebalancing part of your routine will increase your chances of reaching your financial goals – so you can enjoy a secure retirement.

Are you familiar with rebalancing, or does it seem like a new concept? Tell us what you think.