Financial Planning

Staying on Course: The Pros of Portfolio Rebalancing


For most investors, the importance of having an asset allocation that appropriately reflects long-term goals, short-term needs, age and risk tolerance is a practice that is well understood and willingly embraced. Whether a young investor starting out with an aggressive 80/20 stock to bond allocation to maximize long-term growth, or an older investor approaching retirement with a 40/60 stock to bond allocation to reduce market risk, we each have a target allocation suitable to our unique circumstances.

Over time, however, a portfolio’s allocations often increase or decrease from intended targets. Typically this is the result of an extended bull market where the sustained positive performance of stocks can markedly overweight your equity holdings. In fact, it’s not unheard of for a 50/50 stock to bond portfolio to shift to 75/25 during a prolonged rising market. But allocations can also drift (albeit to a lesser degree) as a result of short-term market volatility brought about by seismic events such as BREXIT1.

Tax-smart rebalancing

The real question isn’t whether you should rebalance your portfolio, but rather when and how frequently. That’s because portfolio rebalancing requires the buying and selling of securities, and therefore can potentially trigger long-term capital gains taxes. Done thoughtfully and strategically, however, there are several ways to effectively rebalance your portfolio while keeping any tax implications to a minimum: 

  • Threshold-based vs. time-based rebalancing – often both advisors and investors rebalance on a fixed periodic schedule (e.g., every 6 or 12 months). Despite the fact that allocations may only have shifted a few percent, this periodic approach may trigger a taxable purchase or sale transaction to bring the allocation back in line. Conversely, by instead establishing a threshold trigger (e.g., any allocation drift in excess of 5%), the frequency of rebalancing can be reduced, allowing the portfolio to weather short-term bouts of volatility.
  • Assess your allocations holistically – investors frequently make the mistake of looking at their taxable accounts in a vacuum rather than viewing their asset allocation holistically across both taxable accounts and tax-exempt retirement accounts (e.g., 401k and IRAs). Often, an allocation imbalance that occurs in a taxable account can be easily and effectively offset by rebalancing the holdings in a retirement account, thereby avoiding any taxable distributions resulting from the sale of investments.
  • Don’t automatically reinvest dividends and interest – in addition to rising stock prices, one of the leading contributors to higher than intended equity allocations is the tendency of investors to reinvest dividends and interest back into the stocks that are generating them. Instead, consider having all dividends and interest “swept” into cash which then can be deployed (along with any additional investments) to rebalance the account through new purchases of underweighted holdings rather than necessitating the sale of one or more stocks.

Long-term market cycles and short-term volatility are both essential components of a healthy, vibrant economy and stock market. But considering that the current bull market (which began in March 2009) is now the second longest in our nation’s history, many of you who haven’t undertaken a rebalancing of your portfolio recently might be surprised by how heavily overweighted to stocks your asset allocation has become. Taking a little time now to assess your actual asset allocation versus your target allocation and rebalance may help reduce your overall portfolio risk and better position you to weather any future storms.

For more on retirement and investing planning:

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BREXIT is an abbreviation for "British exit," referring to the UK's decision in a June 23, 2016 referendum to leave the European Union.

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