A tried-and-true axiom of investing holds that a rising tide lifts all boats, which is another way of saying that portfolios are most likely to generate positive performance when markets are going up. While that's a good thing, rising markets also often mean it's time to rebalance your portfolio.
Rebalancing refers to the process of buying or selling securities to maintain the asset allocation selected to match an individual investor's risk tolerance, investment objectives, and time horizon, explains Yvette Bryan, Regional Director, Vice President and Senior Financial Advisor for FTB Advisors, Inc. in Johnson City, Tennessee.
"Once your optimal asset allocation is determined, it is important to rebalance periodically so that the amount of risk you are taking doesn't increase too much, or that you are taking on enough risk," Bryan says.
Recent market performance suggests rebalancing is something many investors might want to look at now. "The year 2017 is a great example of why rebalancing is important," Bryan says. "Some equity markets were up over 20 percent. That implies that what started out as a 60/40 portfolio might have ended up with 72 percent in equities, exposing you to heightened levels of risk."
The Role of Rebalancing
Rebalancing is important because asset allocation is important. Studies have found that much of a portfolio's performance is determined by what percentages of a given portfolio are allocated to the different asset classes.
The two main asset classes in most portfolios are equities, or stocks, and bonds, or fixed-income investments. An evenly balanced asset allocation would be 50 percent equities and 50 percent bonds. However, a financial advisor may suggest varying from that standard, depending on the investor's attitude toward risk, their objectives, and their investment time horizon.
In the case of someone saving for retirement, a younger and more risk-tolerant investor would often have a larger percentage of their investment portfolio in equities. A risk-resistant retirement saver nearing the end of his or her career might be significantly more invested in bonds or other fixed-income investments.
Helping to determine the appropriate asset allocation is one of the first tasks a financial advisor has when taking on a new client. However, the job isn't something to do once and never revisit. A client's changing circumstances — and how the markets perform — require taking a new look at asset allocation every now and then.
How to Rebalance
Rebalancing often involves selling investments that have increased in value and caused the percentage of assets in one class to exceed the target percentage. For instance, if a portfolio's equity investments have risen sharply while bond assets have risen less, rebalancing may call for selling equities and investing the proceeds in more bonds. "You can do it based on the amount the allocations have shifted," Bryan says.
Another way to rebalance is to refrain from selling anything. Rather, an investor may simply stop putting as much or even any money from future contributions into investments in the asset class that has gotten oversized. If future contributions are instead directed to the underweighted asset class, over time the balance will be corrected.
The Limits of Rebalancing
When rebalancing a portfolio, investors should take taxes into account. "In taxable accounts, rebalancing is likely to generate tax liability in rising markets," she says. Investors can discuss the potential impact of selling appreciated securities with their advisors.
One of the challenges of rebalancing is that it can seem counter-intuitive, especially to investors who would prefer to keep investments that have performed well, while selling those that have lagged or produced negative returns. Rebalancing often calls for doing the opposite. The goal is to avoid taking on too much or too little risk to match an investor's risk tolerance, goals, and time horizon.
It's also important to distinguish rebalancing from trying to time the market. Research has shown that investors generally have better long-term results when they don't attempt to sell when the markets are up and buy when the markets are down. Instead, staying fully invested and then rebalancing to maintain optimal asset allocation is the preferred strategy.
When to Rebalance
If markets never rose or fell — and investors' risk tolerance, time horizons, and goals never changed — rebalancing would not be necessary. However, circumstances do change and it's changes in those circumstances that require rebalancing.
Asset allocation needs to be revisited in almost all cases, for instance, as investors age. The closer an investor is to retirement, the less risk a portfolio will generally tolerate. If for any reason an investor begins to feel differently about risk or changes the objective from funding retirement to acquiring a second home, these are also indications that rebalancing is called for.
Bryan says she often suggests rebalancing any time the asset allocation has changed more than 10 percent above or below the target. Another approach is to rebalance on a regular schedule, such as quarterly or annually. "Some people will use a combination of both," she says.
The question of when to rebalance has no hard-and-fast answer, according to Bryan. "This is a topic of great debate in academic circles," she says. "In the absence of taxes, some advocate continuous rebalancing, but we think that is an extreme view. For taxable accounts, we think that annual rebalancing can work in a more tax-efficient manner, but we also believe that if allocations drift beyond pre-prescribed tolerances, rebalancing should be done."
