Periodic rebalancing is generally a good way to keep your investing strategy on track and to prevent your portfolio from becoming too risky during market surges (like the one we’ve been experiencing in recent years) or too conservative after big market setbacks.
That said, I don’t think you have to be a fanatic about it. There may be times when you can skip rebalancing altogether, and sometimes you may be able to bring your portfolio’s balance of risk and return back in line without re-jiggering the investments you already own.
But before I get into when it makes sense to rebalance and the different ways you might want to go about it, I want to be sure we’re all on the same page about what rebalancing is and how it typically works. Here’s a quick review.
Let’s say that after assessing how much investing risk you can handle — which you can do by completing this risk tolerance-asset allocation questionnaire — you’ve decided that investing 60% of your retirement savings in stocks and 40% in bonds represents the right balance of risk vs. return for you. So you invest your savings accordingly, and you also invest any new contributions to your retirement accounts the same way, with 60% going to stocks and 40% to bonds.
But that mix of stocks and bonds in your portfolio will begin changing pretty much right after you set it. When stocks generate higher returns than bonds, stocks will become a larger percentage of your holdings; when the opposite occurs, and bonds do better than stocks, your portfolio’s weighting will shift more toward bonds.
Over the course of a few days, weeks or even months, these variations may not amount to much. So the difference in your portfolio’s risk level may be trivial. Over longer periods, however, it’s possible that you could stray significantly from your target asset mix, in which case you’d have a mismatch between the level of risk in your portfolio and the amount of risk you want to take.
Rebalancing is simply a technique for dealing with that mismatch, specifically a way to bring your portfolio’s risk level back in line with your risk tolerance. Typically, you rebalance by selling some assets and re-investing the proceeds into others. If stocks have outperformed bonds, you would sell stocks and plow the money into bonds. If bonds have returned more than stocks, you’d do the opposite. To the extent you can do such buying and selling in tax-advantaged accounts like a 401(k) or IRA, you can avoid triggering taxes on any sales that result in capital gains.
Just to be clear: rebalancing doesn’t boost your long-term returns. If anything, to the extent rebalancing forces you to cut back on your stock holdings and put more money into bonds, it reduces the return you’re likely to earn over the long-term, as stocks tend to outperform bonds over long periods. Rather, the aim in rebalancing to manage risk. It’s a way to keep your portfolio’s stocks-bonds mix in synch with your tolerance for risk.
There are plenty of theories about how frequently investors ought to rebalance. Some advisers recommend once a year, others suggest you rebalance quarterly or even monthly. Still others contend you should rebalance whenever your target percentages for assets vary by a certain margin, say, if a 60 per cent stocks position grows to 65 per cent or more or shrinks to 55 per cent or less. I think annual rebalancing probably makes the most sense, as I doubt that most investors have the inclination or discipline to monitor and adjust their allocations more frequently.
But while rebalancing annually may be a decent guideline, that doesn’t mean you necessarily have to rebalance every single year. Some years, the difference in returns between different assets may not be large enough to go to the trouble of rebalancing. In 2015, for example, the stock market returned roughly 1.4%, while the broad bond market gained about 0.6 per cent.
