Should You Rebalance Your Investment Portfolio?

Written by: Martin Shields, CFP®, AIF ®

Let’s first start by defining what portfolio rebalancing entails.  This process brings the asset classes in your portfolio back to their target weight from either overweight or underweight positions.  This entails selling your fastest growing assets and buying assets classes that have been underperforming. It is a prudent way of making sure the risk allocation of your portfolio stays within an acceptable range.

The graphic below is a good illustration of how the asset allocation of an investment portfolio drifts over time and what happens through the process of rebalancing.

Over time, it can help reduce the volatility of a portfolio and improve your risk-adjusted return but there are a number of criteria that need to be met with completing rebalancing.

These include:

• • • Timing
    • Alternative Assets
    • Individual Stocks
    • Tax Ramifications
    • Sub Asset Classes
    • Volatility

Timing Should Be Years Not Months

You should establish parameters around when you will rebalance, and you should systematically rebalance your portfolio when you reach those targets.  The best approach is a combination of percentage variation from target and number of years.  The larger you make those rebalancing parameters the better your long-term performance will be.  Parameters of a 5-10% variation from a target weighting or every 5 years are large enough to maximize portfolio performance while controlling the portfolio risk.

Sometimes Rebalancing Involves Alternative Assets

There can be times like we are currently experiencing when you want to potentially rebalance out of one asset class but not into an existing asset class. Instead, into an alternative asset class.  This is the case currently with bonds.  It may be a good time to reduce your equity allocation back to target after the strong performance over the past several years, but you may want to identify a different asset class other than bonds to rebalance into given the headwinds they are experiencing with rising interest rates.  In this case, the alternative asset class could be hedge equity or preferred equity.

Rebalancing Doesn’t Necessarily Apply to Individual Stocks

Rebalancing with individual stocks is probably not a good idea because the stocks that are doing well will probably tend to move higher and the ones that are underperforming may continue to underperform.  This is a stark difference when discussing stocks versus asset classes where there is a rotation between top performing and underperforming asset classes.  The one rule you can use when it comes to individual stocks is managing the percent that makes up your total investable assets.  A good rule of thumb is to keep an individual equity position to below 10-15% percent of a portfolio.

Tax Ramifications Need to Be Considered

Rebalancing in IRA accounts is more straightforward as there are no tax ramifications of selling positions.  In taxable accounts, it will be beneficial to increase the rebalancing parameters and be more strategic to rebalance in years when your income might be lower or when you have some losses to offset gains.

Sub Asset Classes Should Be Included in the Rebalancing

It is important to not only consider the major asset classes when rebalancing but to also consider sub asset classes.  An example of this is large cap growth stocks have done tremendously well over the past 10 years while small cap value has strongly underperformed. Rebalancing some of your large cap growth to small cap value can add a great deal of value to your portfolio over the long-term.

You Especially Need to Balance in Times of Volatility

During times of higher volatility, it can be difficult to rebalance because this will probably entail selling conservative assets like bonds and buying equities that are depressed.  With that said, this type of rebalancing can add tremendous value by buying stocks at depressed levels and benefitting from the subsequent rally after the volatility.   

If you systemically implement rebalancing in your portfolio using these criteria you will help improve the long-term performance of your portfolio and lower the volatility.  If you have any questions regarding your portfolio and how you are allocated, please feel free to contact our office to receive a free consultation and portfolio review.

Related Article: Should My Investment Allocation Become More Conservative in Retirement?

Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.