Yellowstone Financial, Inc.

Should You Rebalance Your Portfolio?

With many investment categories currently down for the year, now could be an ideal time to rebalance your portfolio.  If you’re a casual investor, you may have heard about rebalancing, wondered what it means, and questioned whether it applies to your situation.   In this column we will cover the basics of rebalancing and also investigate whether your investments require it.

Rebalancing is the process of evaluating your stock and bond investments to determine whether they have moved significantly from your original targets.  If so, you perform trades in your various accounts in a tax-efficient manner to return to your original design.  Through the process of rebalancing, you ensure that your investments are aligned with your goals while taking an appropriate level of risk.  If you simply leave your investments alone year after year, you may be taking much more risk than is appropriate for your situation.

To cite an extreme example, imagine a portfolio invested 70 percent in stocks and 30 percent in bonds at the beginning of 2009.  If you just left the investments alone, your portfolio is now 86 percent in stocks and 14 percent in bonds because stocks have appreciated at a much greater rate than bonds.  This is the good side of leaving your portfolio alone!  Of course, we are in the longest bull market in history so it makes sense to see how your portfolio would perform during a bad bear market, such as the Great Recession ten years ago.

Severe bear markets in the past have resulted in US stocks declining by 50 percent.  If you have $100,000 in that 70 percent stock portfolio it would decline by about $35,000, while that 86 percent stock portfolio would decrease by $43,000.  If that doesn’t seem like much of a difference, consider that after such a bear market the first portfolio must appreciate 54 percent to get back to your original $100,000, while the second “leave-it-alone” portfolio needs to increase 75 percent.

Assuming you agree that rebalancing is a good idea, how should you go about implementing it?  Your mutual fund investments may already do this on their own.  If you’re invested in a target date retirement fund, this is already covered for you.  The whole point of these funds is to programmatically invest you in an asset allocation designed to maximize your retirement benefit at an appropriate level of risk.  The target funds rebalance automatically.   Though I would recommend that you understand how aggressive your fund is by looking it up on Morningstar or another resource as different fund companies have different philosophies about how much risk you should be taking at your age.

Key to rebalancing is a personal investment policy statement that details how much you should be invested in stocks and bonds, and how often you should rebalance.  In its simplest form, it could state 70 percent in stocks and 30 percent in bonds, with a rebalance planned every 12 months.  More complex versions may get down to targets for smaller asset classes, such as US small company and international emerging market stocks.

With a target stock and bond mix in place, evaluate your different investment accounts including all retirement funds to consider your current allocation.  An old-fashioned spreadsheet could do the trick or use analysis tools at the investment firms you use today as many consider funds held with different investment companies.  With these tools, you can see whether you need to increase stocks or bonds (or the smaller asset classes) to reach your target.

Let’s assume that your portfolio has grown to 75 percent in stocks from a 70 percent target.  How should you go about reducing this holding?  If you have a taxable investment account outside of a retirement plan, most likely you will not want to sell stocks in that account because you will generate a capital gain, meaning taxes paid on your profits.  Instead look to those accounts where buying and selling does not have immediate tax ramifications.  Retirement plans such as 401(k) and 403(b) plans, as well as traditional and rollover IRAs, Roth IRAs, and variable annuities allow you to rebalance without a tax hit.

With all of these steps, you may have rightly concluded that rebalancing can be a chore!  How often should it be done?  In all but the most extreme markets, studies suggest the right interval is about once a year.  This has the added benefit that if you must sell investments in your taxable account, you benefit from long term capital gains tax treatment, which means a smaller bill come tax time.