Be honest. You’ve not touched your portfolio since the pandemic began. You were too frozen to make any changes when markets were teetering on the brink of disaster last year in March. Then, before you finished thawing, your portfolio unexpectedly climbed to all-time highs in the face of increasing infections and one of the worst economic recessions in history.
If you began early March 2020 with a 60% stock and 40% bond (often referred to simply as 60/40) portfolio made up of stock and bond mutual funds or exchange-traded funds (ETFs) and did not touch your portfolio until now, your allocation would now be around 75% stocks and 25% bonds. That is a significantly different risk profile than 60/40. You’ve gone from an intended conservative growth allocation to one with a higher risk level in a short span of a year.
The critical question is, what should you do? Should you rebalance your portfolio back to your intended allocation? Why is portfolio rebalancing necessary?
Importance of Rebalancing
Buy Low/Sell High
Having a regular rebalancing process allows you to achieve what has been a successful tried and true investment strategy—buying low and selling high. Rebalancing is a disciplined way of selling some of your winners and buying some of your losers. In this case, your losers might be asset classes that have not appreciated as much during a specific period but still belong in your portfolio long term. For example, the losers could be bonds. Or, the losers could be other parts of the growth allocation like foreign stocks, or a combination of stocks and bonds. Ultimately, in the long run, your portfolio performance greatly benefits from rebalancing regularly and this buy low/sell high strategy.
Rebalancing does not guarantee higher investment returns but does help smooth out volatility and reduce risk levels. For example, a portfolio with 75% in stocks has higher risk than a portfolio originally intended to have 60% in stocks. A lower risk level may help you sleep better at night.
Once you understand the importance of rebalancing, you are more likely to take action and not let distractions get in the way of suitably allocating your investment portfolio.
The thought of reducing exposure to stocks and increasing bonds during a bull market is hard to swallow. As the equity portion of your portfolio continues climbing, bonds seem to be stuck in the mud. Many investors tend to let the winners run for as long as possible, though it makes the rebalancing decision even harder the longer this persists. They think bull markets will continue indefinitely, and we know they never do.
The downside risk from an unbalanced portfolio increases the longer it stays unbalanced. Either an investor makes adjustments to their allocation, or the market will make those adjustments. I’ve found that it is more painful for investors to experience having markets rebalance their portfolios instead of adhering to a disciplined rebalancing strategy.
The Tax Man
Partially selling winners to rebalance your portfolio back to your original target allocation can trigger capital gain taxes if you own assets outside of retirement accounts. If you have large unrealized capital gains in taxable accounts, it may prohibit investors from selling.
We have an old saying at Bloom Advisors: Don’t let the tax tail wag the dog! In other words, why let a 15% capital gain tax impact the 85% you keep?
Investors need to understand capital gains and how capital gain taxes work. I think having a good grasp of your tax situation will allow an investor to rebalance where appropriate, even if most of their assets are in taxable accounts.
Often, a person’s most significant investment account is their employer 401(k) account. If that describes your situation, rebalancing is more manageable without the threat of capital gain taxes. However, if an investor is fortunate to have several account types like 401(k)s, IRAs, Roths, and joint/individual/trust brokerage accounts, they may have more flexibility.
Schedule a Portfolio Review
Add a rebalancing reminder to your calendar, and stick to it. You can review your portfolio annually or semi-annually, whatever makes you comfortable, but make sure you do it.
Auto Rebalance your Employer Plan
Many 401(k) websites offer automatic rebalancing with a touch of a button. Auto-rebalancing works well if your primary portfolio is your retirement plan, but you will have to rebalance your entire portfolio if you have outside accounts to do it properly.
If you are concerned about taking too much off the table, consider rebalancing halfway to your target allocations instead of fully back. Of course, your portfolio will still be outside of its target, but at least you have moved closer to it.
Hire an Advisor
If you find portfolio rebalancing challenging to accomplish, you should consider hiring a registered investment advisory firm to help you. Working with an investment advisory firm takes some of the emotion away from financial markets and allows portfolio adjustments to be made regularly.
Whether you are a do-it-yourself investor or choose to seek professional help from an investment firm, having a proper investment allocation coupled with a disciplined rebalancing process is critical to achieving success. It ensures you remain diversified and on track to reach your financial goals.