What Is Portfolio Rebalancing And How You Can Benefit From It?
Hi everyone, my name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner. One of the reasons I do educational videos because I want people to have access to high-quality financial knowledge and insights. Today, I am going to talk about portfolio rebalancing.
So, what is portfolio rebalancing?
Portfolio rebalancing is returning your current investment allocations back to its original target investment allocations, going back into balance.
What does that mean? For example, let’s say you start with a baseline of 60% stocks and 40% bonds portfolio a couple of years ago. Right now, your portfolio is 70% stocks and 30% bonds because of the appreciation in stocks. To get back to your baseline, you do portfolio rebalancing by selling some stocks then using that money to buy bonds to get back to 60% stocks and 40% bonds.
Why do you need to rebalance your portfolio?
There are two reasons why you may need to rebalance a portfolio:
1. Managing risk. The stock market fluctuates. Some investments do better or worse than others. Stocks are riskier than bonds because stocks have a higher risk of loss, but also generate higher returns compared to bonds in the long run. Therefore stocks tend to increase in percentage in your portfolio over time.
For example, based on your risk tolerance, you should be in a 60% stocks and 40% bonds portfolio. If you start out with a 60% stocks and 40% bonds portfolio and later your portfolio is 70% stocks and 30% bonds due to market fluctuation, you are exposed to unwanted risk. Rebalancing the portfolio helps keep the risk level of the portfolio consistent with your risk tolerance.
2. There are also studies that show rebalancing can increase total return because you are selling what is high then buying what is low. Like the methodology of buy low and sell high.
When should you rebalance?
There are three strategies:
1. Pick a date. It could be in April when you are doing your taxes or in December to take advantage of tax loss harvesting at the end of the year. Tax loss harvesting is realizing a loss and using that loss to offset a realized gain or realized the loss so you can minimize your tax burden on your tax return while maintaining your target investment allocation. Also, on a side note, with technology nowadays, tax loss harvesting can be done daily and not just at the end of the year.
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2. You can rebalance when it is outside of your tolerance bands. For example, you pick a tolerance band of 5%. Which means when an investment shifts plus or minus 5%, it’s time to rebalance. Going back to our example of a 60% stocks and 40% bonds portfolio, when stocks are more than 65% or less than 55% of the portfolio, it’s time to rebalance. When bonds are more than 45% or less than 35% of the portfolio, it’s time to rebalance. That is just one way to calculate tolerance band upper and lower limits.
Another way is a percentage of a percentage position. For example, a 5% tolerance band is 5% of the percentage position. Plus and minus 5% tolerance band of 60% stocks position is 63% (.60 X [1 + .05] and 57% (.60 X [1 - .05]). Plus and minus 5% tolerance band of 40% bonds position is 42% (.40 X [1 + .05]) and 38% (.40 X [1 - .05]). A rebalancing would only be trigger once the position actually crosses that higher or lower limits.
Two things to keep in mind:
One, in regards to picking the tolerance band to rebalance, it’s really up to the investor. Instead of a 5% tolerance band, they may want a 10% tolerance band because they want to ride the momentum. Please be aware that you take on more risk the wider the tolerance band is.
Two, different asset classes can have different tolerance bands because of their volatility. For example, I went on Yahoo Finance to compare the biggest 500 companies in the US, also known as S&P 500, and compared it to a bond fund for the last 10 years. The S&P 500 is the blue line and the bond fund is the red line. As you can see, the blue line is more volatile than the red line. The red line should have a lower tolerance band than the blue line. If the red line has a high tolerance band, it may not get rebalanced frequently enough. If the blue line has a low tolerance band, it will constantly need to get rebalanced.
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3. You can use a combination of the two strategies, pick a date and use tolerance bands.
A good client of mine ask me, what do most people do? I told her most people, but not all, don’t rebalance their portfolio because they don’t know about rebalancing and how to do it in a cost and tax efficient matter. And that is one of the reasons this educational video is so important.
Now that you understand a little more about what is rebalancing, let’s talk about the actual rebalancing process.
There are four steps to the rebalancing process:
- First, determine your target asset allocation for your portfolio based on your risk tolerance and objective.
- Second, define when you need to rebalance and have a disciplined approach.
- Third, define your portfolio’s current asset allocation.
- And fourth, if you need to, determine what you need to buy and sell to get back to your target asset allocation.
What are the ways to rebalance?
There are many ways to do that.
You can use one or any combination of these strategies to rebalance your portfolio.
You can:
- Option A, use current money. Selling highs and buying lows. Selling appreciated investments then using that money to buy other investments to align with your target asset allocation.
- Option B, use new money to buy under-weighted asset classes.
- Option C, use dividends and capital-gains distributions to buy under-weighted asset classes.
- Option D, withdraw from over-weighted assets classes. Let's say you are a retiree and you need to withdraw from your portfolio to live. You can withdraw money from over-weighted asset classes to rebalance the portfolio.
Reminder:
Rebalancing can get a little tricky when you have multiple accounts, like taxable accounts and tax-advantaged accounts. You have to run the numbers to see where to buy and sell. Maybe you keep the taxable accounts the way they are and only rebalance the tax-advantaged accounts because with taxable accounts, realized gains are taxable.
Due to market movement, you could be exposed to more risk than you originally intended if you don’t rebalance the portfolio.
Although there are a couple of ways to rebalance a portfolio, the most important thing is to pick a method and stick to it.
When your goals, time horizon, or risk tolerance have changed, chances are, your asset mix in your portfolio would have changed too. So before you rebalance the portfolio, be sure to check to see if your goals, time horizon, or risk tolerance have not changed because if it has, then you might actually have a new target asset allocation.
Portfolio rebalancing could protect you from trading based on emotions.
Rebalancing is a simple concept, but sometimes it can be complicated in practice because of the investor unique circumstances, types of accounts involved, trade fees, and taxes if applicable.
The key takeaway is that there is no ONE way or ONE ultimate strategy for rebalancing your portfolio just like how no one can predict the stock market. We can only learn from historical data and make our best and educated judgment as an industry to determine when to rebalance. We don't have to have a perfect plan. Just have a rebalancing strategy and stick to it.
I hope the information was helpful and practical. Until next time. This is Tan, your trusted advisor.
This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.
Please do not excerpt or copy this information without prior consent from TAN Wealth Management.