Rebalancing Your Portfolio

Rebalancing keeps your portfolio aligned with your target allocation. This disciplined practice manages risk and can enhance returns over time. [DEFINITION] Rebalancing: Periodically buying and selling assets to restore your portfolio to its target allocation after market movements have caused it to drift. ### Why Rebalancing Matters Over time, different asset classes grow at different rates: - Strong stocks may grow from 60% to 75% of portfolio - Your risk level increases without you deciding - Rebalancing restores your intended risk exposure [EXAMPLE] Target: 70% stocks, 30% bonds. After a bull market: 82% stocks, 18% bonds. You now have more risk than intended. Rebalancing sells some stocks and buys bonds to return to 70/30. ### Rebalancing Methods **Calendar rebalancing:** - Fixed schedule (annually, semi-annually, quarterly) - Simple and consistent - May rebalance when unnecessary **Threshold rebalancing:** - Rebalance when allocation drifts beyond set limits (e.g., ±5%) - More responsive to market moves - Requires monitoring [KEY] Annual rebalancing is sufficient for most investors. More frequent rebalancing creates transaction costs and tax events without significant benefit. ### How to Rebalance **Option 1: Sell high, buy low** - Sell overweight assets - Buy underweight assets - Triggers taxable events in taxable accounts **Option 2: Redirect new contributions** - Direct new money to underweight assets - Avoids selling and taxes - Slower to rebalance **Option 3: Rebalance in tax-advantaged accounts** - Sell and buy in IRA/401(k) - No tax consequences - May need other methods for taxable accounts [TIP] In taxable accounts, use new contributions to rebalance first. Only sell if necessary, and consider tax-loss harvesting opportunities. ### Setting Rebalancing Thresholds Common approaches: - **5% absolute:** Rebalance when any asset class drifts ±5 percentage points - **20% relative:** Rebalance when any asset class is ±20% from target - **Annual with threshold:** Annual check, rebalance only if threshold exceeded [EXERCISE] Your portfolio target is 60% US stocks, 25% international, 15% bonds. Current: 68% US, 22% international, 10% bonds. What trades would you make to rebalance? |ANSWER| Sell 8 percentage points of US stocks. Use proceeds to buy 3 percentage points of international and 5 percentage points of bonds. This returns you to 60/25/15 target allocation. ### Tax Considerations **Tax-efficient rebalancing:** 1. First, adjust in tax-advantaged accounts (IRA, 401k) 2. Second, redirect new taxable contributions 3. Third, use dividends and distributions 4. Last resort: Sell in taxable accounts (prefer long-term gains) [WARNING] Frequent rebalancing in taxable accounts can create unnecessary tax liability. The tax cost may exceed the benefit of precise allocation. ### Rebalancing and Returns Counterintuitive benefit: Rebalancing often enhances returns because it enforces "sell high, buy low" discipline. When stocks surge: - You sell some stocks (selling high) - You buy more bonds (often undervalued relatively) When stocks crash: - You sell some bonds - You buy more stocks (buying low) ### Automated Rebalancing Many brokers offer automatic rebalancing: - Robo-advisors (Betterment, Wealthfront) rebalance automatically - Some 401(k) plans offer auto-rebalancing - Target-date funds internally rebalance [SCENARIO] You haven't rebalanced in 3 years. Stocks have surged. Your 60/40 portfolio is now 80/20. A major correction hits and stocks fall 30%. How does this feel versus if you had rebalanced? If rebalanced to 60/40 before the correction: You lose 18% (60% × 30% stock loss). Actual 80/20: You lose 24% (80% × 30%). That's 6 percentage points more loss—on a $100,000 portfolio, $6,000 more lost. Regular rebalancing would have reduced your exposure before the crash.