Rebalancing Your American Funds Portfolio: A Step-By-Step Guide

Rebalancing your investment portfolio is an important way to manage risk and maintain your desired level of risk over time. It involves buying and selling assets to bring your portfolio back to its original asset allocation. For example, if you originally invested 70% of your portfolio in stocks and 30% in bonds, but the value of the stocks has since increased, you would be taking on more risk than you originally intended. To rebalance, you could sell some of your stocks and buy more bonds, or simply invest any new money into bonds until the portfolio is balanced again.

There are several rebalancing strategies, including calendar-based rebalancing, threshold-based rebalancing, and a combination of the two. Calendar-based rebalancing involves reviewing and adjusting your portfolio at set intervals, such as quarterly or yearly. Threshold-based rebalancing is triggered when your portfolio deviates from your target asset allocation by a certain percentage, such as 5%.

It's important to monitor your portfolio and rebalance at least annually to ensure your investments remain aligned with your financial goals, risk tolerance, and investment strategy.

How to determine your ideal portfolio mix

Determining your ideal portfolio mix is key to effective rebalancing later. Your ideal portfolio mix should be based on your individual risk tolerance and investment goals.

One method of determining your ideal portfolio mix is the Rule of 110. Subtract your age from 110 to determine what percentage of your portfolio should be allocated to stocks, with the remainder mostly in bonds. For example, if you are 40 years old, around 70% of your portfolio should be in stocks, and the remaining 30% in bonds.

However, it's important to also consider your individual circumstances. If you consider yourself to be a risk-tolerant person and short-term market fluctuations don't bother you, then your portfolio could shift in favour of stocks. On the other hand, if stock market volatility keeps you up at night, then you can allocate more money to bonds or even to cash.

When determining your ideal portfolio mix, it's also important to keep in mind that you will need to continuously monitor your financial situation and adjust your portfolio as circumstances change over time. For example, your investment time horizon is always getting shorter, and an asset mix that worked for a goal originally 20 years away might not be appropriate when your goal is only 5 years away.

When to rebalance your portfolio

There are two general approaches to how often you should rebalance your portfolio. The first is based on time. You might rebalance your portfolio once a quarter, once every six months, or once a year. This approach is simple and removes psychological factors that can cause investors to make changes during extreme market fluctuations.

The second approach is to rebalance based on tolerance thresholds. For example, you might rebalance an asset class when its allocation deviates from the planned allocation by a certain percentage, such as 20%. Using this method, you set a reminder on your calendar and stick to it.

While there is no perfect rebalancing solution, it is important to rebalance at least annually to minimize the risk of your portfolio deviating from your original asset allocation.

How often a person rebalances their investment portfolio, including their 401(k), depends on various factors such as age, risk tolerance, salary allocation, and more. Professionals recommend that individuals rebalance their 401(k) portfolios every quarter, but doing so once a year is also sufficient.

How to rebalance your portfolio

Rebalancing your investment portfolio is an important way to maintain your desired level of risk and return potential. It involves buying and selling assets to return to your original asset allocation strategy, which is based on your risk tolerance and investment goals. Here are the steps to rebalance your portfolio:

Record:

Keep a record of the total cost of each security and your portfolio as a whole when you first purchase them. This will provide you with historical data to compare with current values in the future.

Compare:

On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of each asset class by the total current portfolio value. Compare this figure to the original weightings.

Adjust:

If you find that changes in your asset class weightings have altered your portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amounts that should be invested in each asset class to maintain your original asset allocation.

You may want to sell securities from asset classes whose weights are too high and purchase additional securities in asset classes whose weights have declined. However, when selling assets, consider the tax implications of readjusting your portfolio. For example, if you sell profitable investments within a year, you will be charged a tax equal to your ordinary income tax bracket. If investments are sold after a year, they will be charged the capital gains tax, which is usually less than the ordinary income tax.

Alternatively, you can rebalance your portfolio without selling by buying more assets of the asset class that is currently undervalued. You can also avoid taxes by placing your portfolio in a tax-advantaged account, such as an individual retirement account (IRA).

Rebalancing Strategies:

There are several rebalancing strategies you can use:

• Calendar-based rebalancing: This method designates a frequency for resetting the portfolio back to the target asset allocation, such as quarterly or yearly.
• Threshold-based rebalancing: This method is triggered when a portfolio's asset allocation deviates by a certain threshold, such as 5%. One drawback is that it requires regular monitoring.
• Calendar- and threshold-based rebalancing: This approach combines both rebalancing strategies. Based on a calendar frequency, the portfolio is rebalanced if its assets have strayed by more than a specific percentage from the target allocation.

The optimal frequency for rebalancing depends on various factors, such as transaction costs, personal preferences, age, risk tolerance, and tax considerations. Generally, rebalancing at least once a year is recommended, although some investors prefer to do so quarterly or twice a year. Less frequent rebalancing may lead to greater stock allocations, higher overall returns, and increased volatility.

How often to rebalance your portfolio

There is no one-size-fits-all answer to how often you should rebalance your portfolio, but there are several schools of thought on the subject.

Calendar-based rebalancing

One approach is to rebalance your portfolio at specific time intervals, such as monthly, quarterly, or annually. This method is straightforward and doesn't require constant monitoring of your investments. However, it may result in more frequent rebalancing than necessary.

Threshold-based rebalancing

Another strategy is to use a threshold or trigger for rebalancing. This involves rebalancing when your asset allocation deviates from your desired allocation by a certain percentage, such as 5%. This approach ensures that your portfolio stays within your risk tolerance levels and is more closely aligned with your financial goals. On the other hand, it requires regular monitoring and may lead to frequent rebalancing during volatile market periods.

Combination of both

You can also combine both calendar-based and threshold-based rebalancing. For example, you can set a calendar frequency for rebalancing and also adjust your portfolio if its asset allocation deviates significantly from your target.

Research findings

Research from Vanguard suggests that there is no optimal rebalancing strategy in terms of portfolio returns. Whether you rebalance monthly, quarterly, or annually, the returns are not significantly different. However, checking your investments too frequently may lead to emotional decision-making that deviates from your long-term goals. Therefore, it's important to maintain a balanced risk profile over time, regardless of how often you check.

Pros and cons of rebalancing

Advantages of Rebalancing

• Rebalancing returns your portfolio to your original risk tolerance and desired level of risk, reducing the chance of your portfolio dropping in value.
• It improves diversification by ensuring your portfolio is not weighted too heavily towards one stock, which could magnify the impact of that stock on overall performance.
• It avoids the potential for emotions to interfere with your buy and sell decisions.
• It is a natural consequence of investment glide paths that change the asset allocation over time, such as target-date funds.

Disadvantages of Rebalancing

• You may be selling investments that are doing well to buy investments that are not performing as well.
• It is an uninformed strategy that assumes high-flying investments have limited room for growth and that low-performing investments will increase in value.
• It conflicts with other common strategies such as buy-and-hold and harvesting losses to offset capital gains.
• It may increase costs due to transaction charges from buying and selling frequently and higher taxes from realising capital gains.

Frequently asked questions