2021 was a banner year for market growth. That’s great for your investments! So why are we talking about rebalancing?
Now you can sit back and watch your portfolio grow, right?
Just as important as establishing your risk level is the need to monitor your portfolio over time and ensure the asset allocation remains in line with your long-term goals. One way to achieve this is by periodically rebalancing your portfolio.
In simple terms, rebalancing “resets” your portfolio to its original or intended asset allocation. The asset allocation is your desired mix of stocks, bonds, and other potential investments that complement your financial goals, time horizon, and risk tolerance.
Why is rebalancing important? Over time, your asset mix will fluctuate with the ups and downs of the financial markets. Unknowingly, the risk level in your portfolio may drift away from your target. For example, in a strong bull market, your equities may grow such that your portfolio includes more stock market risk than you intended. In these situations where stocks are having a favorable run-up, it can be tempting to let your equity allocation drift higher, but before you know it you could end up having an equity allocation 10 or even 20 percent higher than originally intended. And now if the stock market experiences a substantial pullback, your portfolio will also be subject to much more risk than originally intended. Rebalancing on a regular basis can help mitigate these unintended changes in your portfolio’s risk level.
For example, your financial goals, time horizon, and risk tolerance may lead you and your wealth advisor to implement a portfolio that is invested 50 percent in equities and 50 percent in bonds. After one year, your equities may have grown by 10 percent. Your portfolio is now allocated 60 percent in equities and 40 percent in bonds. This may have increased the risk profile of your portfolio to a level that isn’t consistent with your long-term financial goals. To rebalance your portfolio back to target, you would theoretically sell 10 percent in equities and buy 10 percent in bonds.
How often should you rebalance your portfolio? In a perfect world, with no transactions costs, the optimum policy would be to rebalance continuously. However, intermittent rebalancing is more practical. Two common approaches include calendar-based rebalancing and drift-based rebalancing.
Calendar-based rebalancing refers to rebalancing your portfolio on a regular basis (monthly, quarterly, annually, etc.). This approach eliminates the stress of market timing and is generally easier to implement if you are managing multiple portfolios or accounts.
On the other hand, drift-based rebalancing takes more of an active approach and requires keeping a close eye on your investment allocations. So instead of rebalancing every month, quarter, year, etc., you would rebalance every time your allocations “drift” beyond a given range. Theoretically, this could mean rebalancing very often if your portfolio is subject to extreme volatility.
Every investor is unique, and no single rebalancing rule is best for all situations. You should rebalance frequently enough to ensure your risk level remains relatively consistent, but not so frequent that the benefits are overwhelmed by factors such as transaction costs and tax drag. Also, if your portfolio includes taxable accounts, it may result in realized gains subject to capital gains tax. Depending on your particular situation, you and your wealth advisor may decide on a rebalancing strategy that is sensitive to tax liability.
In summary, reviewing and rebalancing your portfolio periodically is one way to ensure your risk level remains aligned with your target asset allocation and financial goals. Working with a wealth advisor is key in not only determining, but also monitoring, your desired risk level over time. Should you have questions on your investment portfolio or wish to meet with one of our Wealth Advisors to discuss your particular situation, we’re always available to have a conversation! You can get in touch with us by calling 855-855-5455, emailing [email protected], or connecting with one of our team members.