If you've been around long enough in the investing and financial community, you've most likely heard the term "rebalance." Particularly if you are a "set it and forget it" investor, rebalancing is a simple, yet crucial action that will help you stay on track with your investments.
Note: For those of you who don't need a lesson on "rebalancing", skip to the end of this article for an awesome free rebalancing tool.
What is Rebalancing?
The term "rebalancing" refers to resetting your asset allocation back to its original target allocation percentages. In other words, if your investment strategy is to have 60% of your holdings in stocks and 40% in bonds (the classic "60/40" strategy), you would be resetting your holdings back to this 60/40 split at certain time intervals, often a year. Over time, your holdings will grow or be reduced by changes in the market. After a year, your 60/40 strategy might be more like a 65/35 allocation of your assets. The way you rebalance your portfolio is by selling a portion of the assets you hold that appreciated (increased in value) over the specific time period, and buying a portion of the assets you hold that depreciated (decreased in value) over the same period.
Why would you sell some of the winning assets and buy the losers? While it may seem counterintuitive, selling the winning assets allows you to capture some of the gains you earned, and buying the losing assets allows you to fortify your position in them at a lower cost than you originally purchased them at. There are several key advantages to rebalancing.
Key Advantages of Rebalancing:
Managing risk tolerance - you need to know what level of risk you are comfortable taking on. Are you an aggressive investor with many years ahead? Are you nearing retirement and wanting to be more conservative in your approach? Rebalancing allows you to adjust your portfolio back to your desired asset allocation, which should be determined by your assessed level of risk tolerance.
Diversification - rebalancing provides a certain level of protection, particularly in the various cycles of the market. As your winning asset classes outperform, you may find you have an outsized position in that holding after a long period of success. That winning asset may be due for a correction and decline in value. To ensure that your assets are diversified properly across the asset classes you invest in, rebalancing acts as a check to oversized positions in specific assets.
Emotional intelligence - every investor who is moderately involved in a portfolio will struggle with the behavioral psychology that is inherent to investing. Rebalancing at set intervals (i.e. last day of every month, the first day of the new year, etc.) will help you stay principled and emotionally intelligent in your decisions. This can help ensure that you do not act rashly in a moment of greed, fear, or panic, to the possible detriment of your portfolio's performance.
Increased awareness of financial health - one of the simplest benefits of rebalancing is that it allows you to stay on top of your financial investments. A lot of us can't even remember the passwords to our financial accounts, let alone how our assets are performing or growing. Rebalancing helps you to check in on your investments periodically to ensure you are staying on track with your financial goals and long-term objectives.
Tax implications - one strategy that may provide tax benefits to some who qualify is to rebalance just slightly over one year after your last rebalance. This annual approach allows any capital gains earned by some taxpayers to be taxed as long-term capital gains, which are currently taxed at a lower rate than ordinary income (read more about capital gains here). Long-term capital gains are essentially gains realized on specific assets you sell having held them longer than a year. Another potential tax benefit of the annual approach to rebalancing is preventing you from making a wash sale. A wash sale is when you sell a security at a loss within 30 days after purchasing it, which the IRS disallows (source: investors.gov).
So, are there any downsides to rebalancing? Like most things, rebalancing can have some disadvantages, particularly if used improperly.
Key Disadvantages of Rebalancing:
Micromanagement - for those of us who are more hands on and like to stay up to date with our finances, rebalancing can be a temptation to get more involved in your investments than you should. Rebalancing should fit into the overall strategy you've chosen for your long-term investments, and diligently sticking to a strategy is crucial for sustained success. Once you have decided on a rebalancing plan (i.e. asset allocation, frequency of rebalancing, etc.), resist the urge to twiddle with your investment.
Emotional Unintelligence - as many of you are aware, U.S. equities have taken a major hit so far this year. There has been extreme volatility in the stock market due to the uncertainties like the Federal Reserve's plan to raise rates to combat inflation, the lingering Omicron surge, and potential war in Ukraine. If you were planning on rebalancing your portfolio the first week of this year, you may be very hesitant to make any changes in such tumultuous market conditions. You may want to wait a few weeks to see if the market improves, or even wait for a day when the market is up. This is trying to time the market, and can lead to poor long-term performance, as none of us has a crystal ball. If you want to change your investment strategy, consider doing it when the market is calmer, but make sure you stick to your rebalancing plan come hell or high water. This will benefit you in the long-run.
Improper asset allocation - rebalancing is only as good as its underlying investment strategy. If the asset allocation of an investment strategy is garbage, you are just re-sorting the garbage come rebalancing time. Make sure that your investment strategy is in line with your financial objectives and risk tolerance.
Taxes - rebalancing more frequently (i.e. weekly or monthly) can result in short-term capital gains and higher taxes if your assets being rebalanced are not in a tax-advantaged account. Make sure you are properly assessing the frequency of rebalances for your taxable accounts to avoid being stuck with a higher tax bill next year. Rebalancing on a more frequent basis is most tax-efficient in a tax-advantaged account like a Roth IRA, Roth 401(k), or Health Savings Account (HSA).
If the idea of rebalancing is still a little fuzzy, let's look at a case study of how it might look in actual practice.
A Case Study
Suppose Johnny Cash has $1,000 invested in his retirement account. He is a passive investor and likes to be as hands off as possible with his buy-and-hold portfolio. He also considers himself to be a fairly aggressive investor, as he is only 25 years old and plans to work at least another 30 years. As such, he is willing to take on more risk and has allocated 90% of his portfolio to stocks, in this case the S&P 500 (ticker SPY). The other 10% of his money he puts in intermediate term bonds (ticker IEF). Johnny started investing in his retirement account on January 1, 2021. Let's take a look at what happened to Johnny's portfolio by the end of 2021:
Source: Portfolio Visualizer
The pie chart shows his allocation at the beginning of the year. As you can see, his overall Compound Annual Growth Rate (CAGR) for the year was 25.54%, meaning his $1,000 initial investment grew to $1,255 by year's end. However, let's drill down a little further to see what happened here.
Source: Portfolio Visualizer
As you can see in the first chart above, Johnny's 90% allocation of his assets in SPY grew to be 92.3% during the year, while his 10% allocation in IEF actually shrank to 7.7%. Additionally, as shown in the second chart, the SPY holding yielded a return of $259 for the year, while IEF actually had a loss of $3 (we will round down for simplicity), for the net gain of about $256. Now Johnny's SPY allocation is greater than his target of 90% of his portfolio, and conversely his IEF allocation is less than his target of 10%. Johnny now holds $1,159 of SPY and $97 of IEF as of December 31, 2021.
As such, on January 3, 2022 (the first day of trading in 2022), Johnny wants to rebalance his portfolio back to his target allocation of 90/10. In order to do this, he must calculate 90% of his new total portfolio value, which is $1,130.40 (0.9 * $1,256), and this is the target allocation for SPY. He must then sell $28.60 of SPY ($1,159 - $1,130.40) to arrive at his desired SPY allocation. In order to get his IEF holding back to the 10% allocation, he must then use the $28.60 of cash he made from the sale of SPY to buy $28.60 of IEF.
After these transactions, Johnny now holds $1,130.40 of SPY and $125.60 of IEF, back to his original 90/10 target allocation.
Freelanced Finance Rebalancing Tool
Now that you are armed with a working knowledge of how rebalancing works, check out our Freelanced Finance Rebalancing Tool in Google Sheets that is freely available on our Resources page. Our tool allows you to input your current investments, set a desired asset allocation, and then will automatically calculate your adjustments needed to rebalance your assets.
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The opinions expressed in this article are solely the opinions and views of the author. None of the views expressed are to be misconstrued as professional advice or recommendations, but rather for entertainment and recreational enjoyment. Past performance is not and should not be used as an indicator of future performance.