Portfolio Rebalancing: What to Know

We often build a portfolio because we have specific goals we’d like to accomplish and believe that a certain strategy will help us get there. But as any investor knows or will eventually find out, investments don’t always perform as expected, which can cause our plans to drift from their initial appearance.

Therefore, it can be a good idea to take a step back and, every so often, adapt to ensure you stay on track with your original approach. In practice, this involves applying a nuanced concept known as rebalancing, often with the assistance of a financial advisor.

This article outlines what it means to rebalance your portfolio and why it’s important. You’ll also learn about the different types and how you can leverage an experienced professional to help you put it into action.

What Is Portfolio Rebalancing?

Rebalancing is when you correct your portfolio after it has strayed away from your original allocation. It involves selling assets that no longer fit your strategy either due to underperformance, overperformance, or posing a risk to future gains. Then, you would buy new ones with a better fit to replace them.

For example, consider that you’ve invested in a mix of stocks and bonds, weighted at 60% and 40%, respectively. According to Maura Madden, a certified financial planner (CFP) based in Seattle, Washington, it may be time to consider rebalancing “[w]hen different investments or assets grow at different rates.” Per Madden, “If the stock portion of your portfolio grows faster than the bond portion of your portfolio,” increasing to 70% the former and 30% the latter in our example, you may face a lopsided portfolio with a higher risk profile. In this case, she says, “Rebalancing returns each individual…portion of the portfolio to the intended target allocation.”

Rebalancing measures can occur at specific frequencies (e.g., monthly, quarterly, or annually) or as needed. On most occasions, as we’ll explain further, you’ll entrust or work alongside a financial advisor to identify opportunities to adjust your portfolio over time. They’ll firmly grasp which securities no longer align with your strategy and can recommend ideal replacements. If they have discretionary authority over your account, they can implement changes on their own.

Why It’s Important

Several factors solidify rebalancing as an effective strategy. One of the most prominent, though, is that it can help you manage risk and avoid losses due to underachieving investments.

Madden highlights that a significant benefit of the practice is that “it allows you to keep your investment portfolio appropriately allocated.” She continues, “An important element in choosing investments is selecting individual investments that together make up a diversified portfolio that is in alignment with your risk tolerance, your risk capacity, and your required risk.” So, actively aligning your assets with your needs or desires can enable you to mitigate risk.

Rebalancing can also allow you to reconsider how you’d like your portfolio to take shape, whether it stays how you originally envisioned or takes a new form, based on shifts in market conditions or goals. Dr. Andrew Grauberg, president and CEO of ABC Quant, a company that provides risk management software to institutional investors, explains, “Rebalancing is extremely important to adjust current portfolio allocations to match initial portfolio allocation weights (static rebalancing) or new suggested allocations (dynamic) based on advisor’s market views.”

Types of Rebalancing Strategies

Investment management or advisory professionals may use different rebalancing approaches or techniques. This might affect the rate or scale at which they adjust your portfolio. Specifically, there are two primary strategies professionals use:

Static

A more typical tactic, the static process involves returning the composition of your portfolio to its original allocation. In other words, as your investments deviate from your beginning allocation, either weighing too much or too little, you take action to match the percentages you started with.

One of the most common sub-types of this strategy is the calendar approach. This is where your advisor will correct your portfolio at a specified and predictable time, whether it’s once a year or once a month. Madden notes that it’s typical for a professional to “review your portfolio at least annually and rebalance as needed,” but it’s also common for them to do so “semi-annually.”

Another static method you may see is the corridor (or trigger-based) approach. This involves, per Grauberg, rebalancing when “triggered by pre-set thresholds of weight changes.” That is, you and your investment manager will define limits for how much your allocation may drift. Once the asset classes within your portfolio exceed or drop below these targets, it will be time to rebalance.

How much would your portfolio need to drift to trigger a rebalancing? While it can vary, Madden suggests, “A general rule of thumb is to rebalance when the difference between the actual percentage of your portfolio invested in a specific investment is more than 5% from the target allocation.”

Dynamic

The other main form of rebalancing consists of modifying a portfolio’s makeup dynamically to factor in changing markets and preferences of an investor. Grauberg points out that while this method is “more advanced” than its static counterpart, it can be more beneficial.

As market conditions transform, your original strategy may become riskier than you had initially hoped or not as ideal to reach your goals. “In simple words, the initial allocation model made during a bullish equity market and narrow credit spread may be a disaster when market conditions change, e.g. widening a credit spread,” says Grauberg.

When you or your advisor apply rebalancing measures dynamically, you can rethink how you plan to allocate your portfolio in the present and for the future. You may choose to make very few changes or sweeping ones. Ultimately, however, you’ll feel more confident that you’re keeping up with ever-present external factors.

Grauberg emphasizes, “A good advisor should always use a dynamic allocation framework and adjust target portfolio allocations based on current market conditions and forecasting the next market cycle.”

How Financial Advisors Help

Financial advisors are an essential resource when it comes to maintaining a portfolio that aligns with your goals. In short, they’ll be able to use their expertise to tell you when to rebalance and recommend tactics to help you accomplish that task.

In a portfolio management arrangement, it’s not uncommon for an expert to have discretionary control over your account. This means they can make trades on your behalf without your approval. While this gives them significant power and requires a lot of trust, it can be beneficial in the case of rebalancing, as it means they could do it on their own without you needing to worry.

Similarly, robo-advisors often also wield discretionary authority. If you use one of these, you’ll provide the service with details about yourself, which helps it build your portfolio. This typically includes your risk tolerance, time horizon, and goals. Then, over time, the software will automatically detect optimal times to rebalance your portfolio and take measures to keep it on track, much like a traditional human professional would.

If your professional works in a purely advisory role, you must apply the proposed changes on your own. Even so, they’ll likely equip you for most, if not all, of the steps.

“Because I do not manage assets, I make rebalancing easier for clients by reviewing their portfolio and providing them with written instructions on suggested allocations including the specific trades to make for each specific account,” says Madden, a CFP. “If clients desire even more assistance I will log in with them and walk them through the placing of the individual trades,” she continues.

Frequently Asked Questions

Are there any downsides to rebalancing?

Rebalancing is largely a positive piece of sustaining a healthy and on-track portfolio, especially because it involves reviewing your assets from top to bottom and, if using a dynamic approach, enables you to adapt to changes. It does, however, have a few potential negatives to consider:

• Transaction costs. You may incur brokerage expenses when you sell securities or purchase new ones. This may add up if you need to make several changes.
• Losses. Per Grauberg, rebalancing may “harm portfolio performance by penalizing high-performing assets while favoring underperforming ones.”
• Almost always requires professional expertise. Because it can be difficult to know when to rethink your portfolio, you’ll likely need to hire professional assistance, which could be costly.

What is automatic portfolio rebalancing?

This is when an automated investment management service, such as a robo-advisor, corrects your portfolio automatically. It uses advanced algorithms combined with the information you’ve provided to determine ideal times and measures to rebalance.

Does rebalancing affect taxes?

Taxes are a key factor in the rebalancing process. According to Madden, “For investments not held within retirement accounts, selling securities – including when rebalancing – is a taxable event.” This means it’s likely you’ll face paying capital gains tax when making transactions. To know how much you’ll pay, it’s wise to consult with your advisor.

Madden also warns about violating the Internal Revenue Service’s (IRS) wash-sale rule. “A wash sale occurs when you buy a ‘substantially identical security’ within 30 days of selling that same security. The 30 day rule applies to the period both before and after the sale of the security,” she explains. “When you buy the same or very similar security within that 61 day period you forfeit your ability to claim the loss on your tax return. When rebalancing a portfolio you want to be sure that you have not had a purchase of the security, including reinvesting dividends, within 30 days of the sale.”