Rebalancing Your Investment Portfolio: A Guide To Getting Started

Rebalancing an investment portfolio is the process of changing the weightings of assets to maintain your desired level of risk and keep your portfolio in line with your financial goals. This involves buying and selling assets or, in some cases, simply allocating additional funds to either stocks or bonds.

Define your financial goals, timeline and risk tolerance

Before rebalancing your investment portfolio, it is important to define your financial goals, timeline, and risk tolerance. This involves assessing your investment objectives, time horizon, and comfort level with risk. Here are some detailed guidelines to help you through this process:

Financial Goals

Start by outlining your financial goals and objectives. Are you investing for retirement, saving for a down payment on a house, or pursuing any other financial goal? Clearly defining your goals will help you determine the appropriate investment strategies and asset allocation.

Timeline

Consider your investment time horizon, which is the amount of time you plan to hold your investments before needing to access the funds. For example, if you're investing for retirement, your time horizon might be 20 or 30 years. If you're saving for a down payment on a house, your time horizon might be shorter, such as 5 to 10 years. Your timeline will impact the types of investments you choose and how often you rebalance your portfolio.

Risk Tolerance

Risk tolerance refers to the amount of risk you are comfortable taking on in your investment portfolio. It's important to assess your risk tolerance honestly and realistically. Consider how you would react to market volatility and potential losses. Are you comfortable with taking on more risk for potentially higher returns, or do you prefer a more conservative approach to protect your capital? Your risk tolerance will guide the types of investments you choose and the allocation between stocks, bonds, and other assets.

Once you have a clear understanding of your financial goals, timeline, and risk tolerance, you can start building your investment portfolio. Seek the guidance of a financial advisor or use a robo-advisor to help you create a portfolio that aligns with your defined parameters. Remember, defining your financial goals, timeline, and risk tolerance is a crucial step in the process of rebalancing your investment portfolio. It provides a foundation for your investment decisions and ensures that your portfolio remains aligned with your objectives and comfort level.

Understand the tax implications of rebalancing

When rebalancing your investment portfolio, it is important to be aware of the taxes you will incur when selling profitable investments. If you are rebalancing a taxable brokerage account, you should explore options to minimise the sale of high-performing (and therefore highly taxed) investments.

One way to minimise tax consequences is to use new cash contributions to purchase assets that bring your allocation into balance. You can also use stock dividends or bond interest payments from your existing investments for rebalancing.

Another way to avoid taxes is to place your portfolio in a tax-advantaged account, such as an individual retirement account (IRA). This way, you can avoid taxes while rebalancing and only pay taxes when you start withdrawing from the account.

• Start with tax-advantaged accounts: Rebalancing trades in these accounts are tax-exempt, avoiding immediate tax consequences.
• Re-direct cash flows in taxable accounts: Direct new purchases and reinvested distributions into underweighted asset classes.
• Consider cost basis: Look for opportunities to harvest losses or manage cost basis across holdings. In low-income years, sell lower-basis shares, and in high-income years, sell higher-basis shares.
• Explore charitable giving and annual gifting: Gift shares of overweighted holdings with a low-cost basis in a taxable account directly to a charity or beneficiary.
• Keep in mind the timing of fund distributions when rebalancing near year-end: Sell before a distribution to avoid taxes on that distribution.
• Use rebalancing to improve the tax efficiency of the portfolio: Take advantage of rebalancing opportunities to shift the portfolio into more tax-efficient options, such as exchange-traded funds or passive investments.

Compare current and original asset allocation

Comparing your current and original asset allocation is a crucial step in the rebalancing process. Here's a detailed guide to help you through this process:

Record your original asset allocation: When you first create your investment portfolio, it's important to document your asset allocation strategy. This includes determining your goals, age, risk tolerance, and the ratio of stocks to bonds that you're comfortable with. Keep a record of the total cost of each security and your overall portfolio value at this initial stage.

Review and compare your current asset allocation: On a chosen future date, review the current value of your portfolio and each asset class within it. Calculate the weightings of each fund by dividing the current value of each asset class by the total current portfolio value. Compare these weightings to your original allocation percentages. Are there any significant deviations? If your portfolio is still relatively aligned with your original allocation and you don't need to liquidate in the short term, you may consider remaining passive.

Identify deviations and adjust: If there are notable changes in your asset class weightings, it's time to adjust your portfolio to realign with your original allocation. Take the current total value of your portfolio and multiply it by the original percentage weightings assigned to each asset class. These calculations will give you the amounts that should be invested in each asset class to restore your desired allocation.

Rebalance through buying or selling: To rebalance your portfolio, you can either sell securities from asset classes that have become overweighted or purchase additional securities in asset classes that have declined. For example, if your portfolio has drifted towards a higher percentage of stocks than your original allocation, you can sell some of your stock investments and use the proceeds to buy more bonds. Alternatively, you can allocate new money to the underrepresented asset class until you achieve your desired balance.

Consider tax implications: When selling profitable investments to rebalance your portfolio, be mindful of the taxes you'll incur. In some cases, it may be more beneficial to avoid selling by simply not contributing any new funds to the overweighted asset class while continuing to invest in the underweighted classes. You can also explore tax-loss harvesting strategies to minimise taxes. Additionally, consider using tax-advantaged accounts, such as an Individual Retirement Account (IRA), to defer taxes until you start withdrawing.

By regularly comparing your current and original asset allocation, you can make informed decisions to maintain your desired level of risk and ensure your portfolio aligns with your investment goals.

Calendar-based rebalancing

Determining Review Frequency

The first step in calendar-based rebalancing is deciding how often to review and adjust your portfolio. Common intervals include quarterly (every three months) or yearly. Monthly reviews may be too frequent and can incur higher transaction costs, while annual reviews may allow for too much drift in your portfolio composition. Choose a frequency that suits your needs and time constraints.

Analyzing Portfolio Holdings

At each predetermined interval, analyze the current holdings of your investment portfolio. Compare the current allocation of stocks, bonds, and other assets with your original target allocation. This analysis will help you identify any deviations from your desired asset mix.

Adjusting to Original Allocation

If your portfolio has drifted from your target allocation, make the necessary adjustments to return it to its original composition. You can do this by buying or selling assets to match the desired percentages. For example, if your target is 70% stocks and 30% bonds, and it has shifted to 80% stocks and 20% bonds, you would sell some stocks and use the proceeds to buy bonds to rebalance the portfolio.

Considering Tax Implications

When rebalancing your portfolio, be mindful of the potential tax implications. Buying and selling assets may trigger capital gains taxes. To minimize these taxes, consider using portfolio cash flows or new contributions to adjust your asset allocation. Consult with a tax advisor to understand the tax consequences of your rebalancing strategy.

Setting Reminders

To ensure you stick to your calendar-based rebalancing plan, set reminders for yourself. You can use calendar reminders or other tools to prompt you to review and adjust your portfolio at the predetermined intervals. This helps you stay disciplined and on track with your investment strategy.

Advantages of Calendar-Based Rebalancing

In summary, calendar-based rebalancing is a straightforward strategy for managing your investment portfolio. By setting a schedule and making adjustments as needed, you can ensure your portfolio remains aligned with your financial goals and risk tolerance. Remember to consider tax implications and set reminders to stay on track with your rebalancing plan.

Threshold-based rebalancing

With threshold rebalancing, you set asset allocation boundaries and then rebalance whenever they are breached, as opposed to automatically rebalancing your portfolio on a predetermined date. For example, if you have a portfolio with a 50/50 equity/bond allocation and a rebalancing threshold of 5%, you would rebalance when either asset reaches 55/45 of the mix. At that point, you would sell enough of the dominant asset to rebalance the portfolio back to its original 50/50 asset allocation split.

The benefit of threshold rebalancing is that you're only forced to act when there's a significant shift in your asset allocation. This can help to control trading costs, and in a fairly steady market, you may not need to rebalance for a number of years if you can live within a generous threshold. The less you rebalance, the less you may pay out in trading fees, and you could also save on taxes.

When choosing a threshold, consider your risk tolerance. The more risk you can take, the higher you can set your threshold, and the greater your potential returns. Common thresholds used by the financial services industry are 5% or 10% bands, triggered when any asset's proportion of the total portfolio rises or falls by 5/10%.

One drawback of threshold-based rebalancing is that it requires regular monitoring and may not be practical if you manage your own portfolio. However, it enables you to better fine-tune your operations and take more control over costs and the impact of choppy markets.

To implement threshold-based rebalancing, first, choose a threshold that suits your risk tolerance. Then, set asset allocation boundaries and monitor your portfolio to see when they are breached. When the threshold is triggered, rebalance your portfolio by selling enough of the dominant asset to return it to its original allocation.

You can also combine threshold rebalancing with calendar rebalancing, where you designate a frequency for resetting the portfolio back to the target asset allocation. For example, you could decide to rebalance at least annually but also intervene if any asset deviates by more than 5% from its target during the year.

Frequently asked questions