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.

Assets grow at different rates—which means that 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.

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.

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.

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 alternatives than the third. 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.

Automatic Rebalancing with Lifecycle Funds

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.

That's where lifecycle funds, also called target date funds, come in. These funds are increasingly being offered in retirement plans, and are also available to investors outside of retirement plans, too. Each lifecycle fund is designed to have its allocation modified gradually over a period of years, shifting its focus from seeking growth to providing income and preserving principal.

Usually, this is accomplished by reducing your exposure to stocks and increasing the percentage your lifecycle fund allocates to bonds. To make matters simpler, a fund's timeframe is often part of its name. So, in 2015, if you're thinking of retiring in about 15 years, you might put money into Fund 2030. And if your target retirement date is 30 years away, you might choose Fund 2045. Before transferring your balances to a lifecycle fund, you'll want to investigate the fund as you would any potential investment, looking at its objective, fees, manager, historical performance and risk levels, among other details. If it passes those tests, it may be an alternative to consider.

Also keep in mind that lifecycle fund managers may be making allocation decisions assuming that this is your sole investment. Take the time to evaluate lifecycle funds relative to your overall investment portfolio.