How to Rebalance Your Portfolio: 4 Tactics
Rebalancing involves buying or selling assets to diversify and find the right balance between risk and reward.
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Rebalancing is about managing risk, not chasing investment returns.
Rebalancing your portfolio once a year is plenty.
Rebalancing less frequently may be even better if your portfolio is diversified from the outset.
"Don’t put all your eggs in one basket"; "never bet it all on one roll of the die." Whatever proverb you pick, it boils down to the same thing: find the right balance between risk and reward to minimize the chance of heartbreak, sleepless nights and financial distress.
Investors do that via asset allocation — building a balanced portfolio of a diversified mix of assets. That way, when one investment unexpectedly drops, the entire portfolio doesn’t drop along with it.
The basics of diversification
Diversification hedges against risk by spreading money across various assets that don’t typically move together. That helps isolate the damaging effects of drops in any single type of investment to protect the portfolio's overall returns.
You can diversify your portfolio in various ways, such as by:
Asset class: Stocks, bonds, cash.
Company size: Large-capitalization, mid-cap or small-cap stocks.
Geographic location: Foreign companies or domestic ones that conduct a lot of business overseas.
Industry: Consumer goods, energy, technology, health care.
Investing style: Mutual funds that invest in companies poised for rapid growth or ones that offer value; stocks that produce income (by paying out dividends).
Knowing when to rebalance a portfolio
A diversified portfolio's asset allocation will naturally drift over time. For example, if you allocate 40% of your portfolio to stocks, that proportion could quietly become 50%, 60% or more of the value of your portfolio if stock prices rise at a faster rate than the other investments in your portfolio.
This is one reason it's important that you and your financial advisor review your portfolio frequently.
This is also where rebalancing comes in.
Rebalancing means restoring a portfolio to its original asset allocation proportions by buying and selling investments.
4 portfolio rebalancing strategies
Rebalancing is not about completely overhauling your portfolio. It is meant to be restorative, giving your portfolio room to grow while keeping an eye on its overall health. These popular strategies can help you rebalance your portfolio.
1. The “While You’re at It” Strategy
How it works: Every time you invest new money (making monthly or quarterly IRA contributions, for example) or withdraw funds (if you’re already retired and drawing income from an account), identify underrepresented or overweighted asset types in your portfolio. Then beef up your position with each contribution check or lower your exposure with withdrawals.
Why it's handy: A person's investment portfolio often includes multiple financial accounts, such as IRAs, 401(k)s, brokerage accounts, and even long-forgotten paper bonds.
Depending on the size of your portfolio, you may not be able to accomplish all the rebalancing work that needs to be done. In that case, add on one of the other strategies.
2. The “Home Base” Strategy
How it works: If most of your retirement assets in a single account, such as a 401(k) or an IRA you rolled over when you left a job, focus your rebalancing efforts on that main account. Even better if it’s a tax-advantaged retirement account, because selling within the account won’t generate capital gains tax bills.
Why it's handy: What goes on in your biggest investment account can have the biggest effect on the overall health of your savings. But don’t ignore the role your other assets play, especially if those assets are concentrated in one asset class. For example, if you’ve got a separate brokerage account that's mostly invested in growth stocks, you might consider trimming your exposure to similar investments in your main account.
3. The “I Treat All My Children the Same” Strategy
How it works: Treat each separate account as a fully balanced portfolio. Decide on your target asset allocation mix and then deploy the same strategy in each.
Why it's handy: Considering each account’s tax status and investment fees can help minimize what you pay the IRS. However, depending on the investment selection in each account (e.g., your 401(k) fund options versus the wider assortment in a self-directed IRA) you may not be able to invest in the exact same mutual fund in each account. Look for a fund that offers similar exposure or has the same investment objective.
4. The “Sweat the Biggest Stuff” Strategy
How it works: Check your large-cap stock positions first to see if you can rebalance your portfolio by shifting money in and out of those investments.
Why it's handy: U.S. large-cap stocks are the biggest slice of the pie in most investors’ portfolios. (Market capitalization is the value of all of a company's outstanding shares. Large-cap stocks belong to companies with market capitalizations of at least $10 billion.) Any shift can have big effects on an asset allocation.
The more you can avoid fees (such as transaction costs) and taxes, the more of your money is left to compound over time.
How often and when to rebalance your portfolio
You can rebalance your portfolio any time, but these three situations might warrant a special look.
In April (tax time) or December (tax-loss harvesting time): Many investors rebalance their portfolios when they're doing other financial housekeeping, such as preparing their taxes in the spring or taking advantage of year-end tax-loss harvesting.
When an investment shifts more than 5%: When the performance of a single asset changes a portfolio's value by more than 5%, it can be a good time to rebalance. However, be careful about reacting to short-term price movements; you might miss out on potential gains when the asset recovers.
Annually: A once-per-year look is common for many financial advisors, though market swings, tax-loss harvesting and other events can prompt more frequent rebalancing .
» MORE: How taxes on stocks work
