Is It Time to Rebalance Your Portfolio?

When the Autumnal Equinox occurred last week, the sun shone directly on the Earth's equator and the length of day and night was nearly the same all over the world. How is that for symmetry? And what does it have to do with the balance of your investments?

As you say goodbye to the dog days of summer, and hello to the cool air and changing leaves of autumn, consider checking in with your asset allocation to see whether it is still achieving the balance you intended. If not, it may be time to consider rebalancing your portfolio. 

What Is Asset Allocation?

Although there's no official
timeline that determines when
you should rebalance your
portfolio, you may want to
consider whether you need to
rebalance once a year as part of
an annual review of your investments.

When you allocate your assets, you decide—usually on a percentage basis—what portion of your total portfolio to invest in different asset classes, like stocks, bonds, and cash or cash equivalents. You can make these investments either directly by purchasing individual securities or indirectly by choosing funds, like mutual funds, that invest in those securities. As you build a more extensive portfolio, you may also include other asset classes, such as real estate, which can help to spread out, and thus moderate, your investment risk

Asset allocation is a useful tool to manage systematic risk, the risk affecting the economy as a whole, because different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. This is known as diversification

Put another way, you're reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be. This is especially true if your assets are "uncorrelated," meaning they react to economic events in ways independent of other assets in your portfolio. Stocks and bonds, for instance, often move in different directions from each other, which is why holding both of these asset classes can help manage risk. 

Financial services companies make adjustments to the asset mix they recommend for portfolios on a regular basis, based on their assessment of the current market environment. For example, a firm might suggest that you increase your cash allocation by a certain percentage and reduce your equity holdings by a similar percentage in a period of rising interest rates and increasing international tension. Companies frequently display their recommended portfolio mix as a pie chart, showing the percentage allocated to each asset class. 

Rebalancing Your Portfolio

As market performance alters the values of your asset classes, you may find that your asset allocation no longer provides the balance of growth and return that you want. In that case, you may want to consider adjusting your holdings and rebalancing your portfolio. For example, the asset allocation you choose to help you meet your financial goals at an earlier time in life may no longer be the ideal allocation after you've been investing for some time, for instance as you approach retirement. Or, like many investors, you may simply never take the time to modify your allocations, or feel confident doing so. And so you might end up doing nothing.

Although there's no official timeline that determines when you should rebalance your portfolio, you may want to consider whether you need to rebalance once a year as part of an annual review of your investments. Any time can be a good time—and the changing of the seasons can be as good as any.  

Assets grow at different rates so your portfolio might end up out of line with the allocation you have chosen. For example, some assets might recently have grown at a much faster rate. To compensate, you might reallocate some of the value of fast-growing assets into assets with slower recent growth, which may now be poised to pick up steam while recent high-performers slow down. Otherwise, you might end up with a portfolio that carries more risk and provides a smaller long-term return than you intended.

Rebalancing Approaches

You can rebalance your portfolio in different ways to bring it back in line with the allocation balance you intend it to have. Here are three common approaches to rebalancing:

  • Redirect money to the lagging asset classes until they return to the percentage of your total portfolio that they held in your original allocation.
  • Add new investments to the lagging asset classes, concentrating a larger percentage of your contributions on those classes.
  • Sell off a portion of your holdings within the asset classes that are outperforming others. You may then reinvest the profits in the lagging asset classes.

All three approaches work well, but some people are more comfortable with the first two options because they find it hard to sell off investments that are doing well in order to put money into those that aren't. Remember, though, that if you invest in the lagging classes, you'll be positioned to benefit if they turn around and begin to prosper again.

The Cost of Shifting

Keep in mind that account shifting means potential sales charges and other fees. Aside from the costs you might incur, switching out of investments when the market is doing poorly means locking in your loss. If this occurs in a taxable account, you may be able to take a tax deduction. However, if you are rebalancing in a retirement savings account like a 401(k), you can't take a tax deduction on capital losses.

Also, be aware that if your investments have increased in value, selling them to rebalance your portfolio in a taxable brokerage account could result in your having to pay capital gains taxes. For more information, see our article on cost basis.

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