The Importance of Rebalancing Your Investment Portfolio

Let’s assume you and your financial advisor just finished updating your investment portfolio valued at $50,000. Furthermore, it was determined that your asset allocation (your desired mix of stocks, bonds, and other investments in your portfolio) is comprised of 60% stocks ($30,000) and 40% bonds ($20,000). Over the course of the year, the value of your investments will fluctuate, as will the weights of each asset class in your portfolio—meaning you’ll no longer have a 60/40 split. Changing these weights back to their original composition is called “rebalancing.”

Risk tolerance and investing

Before we get into the details of rebalancing, you should first understand the concept of risk tolerance: defined as one’s ability and willingness to tolerate large swings in investment value. After you and your financial advisor assess your risk tolerance (often through a questionnaire and conversations) and risk capacity (how much risk you can accept given your financial situation), he or she will then determine how to best allocate your money among different investments. In the example provided above, this is how the 60/40 split between stocks and bonds was initially determined.

While everyone’s appetite for volatility is different, the risks of not knowing one’s own specific tolerance are the same across the board: take on too much and you might panic; take on too little and you may not reach your goals. The bottom line is that knowing your risk tolerance can minimize the chance you’ll make impulsive decisions due to market volatility.

How portfolio rebalancing works

Let's further assume that stocks dramatically outperformed bonds during a bull market. As a result, the value of your investment portfolio jumped to $55,000—shifting your asset allocation to 70% stocks (valued at $38,500) and 30% bonds (valued at $18,500). However, since having 70% of your money in (inherently volatile) stocks makes you feel uncomfortable, your financial advisor should rebalance your portfolio back to its original state. More specifically, in doing so, he or she would sell stocks that have increased in value and are perhaps nearing their peak (selling high) while buying bonds that have decreased in value but still have merit (buying low).

Why you should rebalance your portfolio

As you can see, the exercise of portfolio rebalancing changes asset weights to keep your risk levels in check and minimize unnecessary risk. Rebalancing is also a fundamental investment strategy that instills the simple tactic of buying low and selling high—therefore also helping optimize the value of your portfolio.

Risks of not rebalancing your portfolio

Nevertheless, if you haven't rebalanced your investment accounts, you aren't alone. According to Gobankingrate.com, about 30% of people haven’t rebalanced their 401k or IRA. While over 33% of people aged 25-54 claim to have never done this, even more concerning is that 29% of people aged 55-64 (nearing retirement) say the same.

One of the biggest risks of not rebalancing is potentially exposing yourself to greater levels of risk than you had initially planned for or are comfortable with. In such a scenario, you could experience significant investment losses—especially if you’ve waited a few years to rebalance.

Exposing yourself to too much risk can also lead to undisciplined investing. That's because emotions (particularly greed and fear) can interfere with your decisions to buy and sell investments. Consequently, big mistakes are possible that can easily derail your future goals. A few good examples? Think back to the start of the COVID-19 pandemic or the financial crisis of 2008, when many investors dumped stocks because they couldn’t bear the thought of losing more money and in turn missed out on future upswings.

How often you should rebalance your portfolio

Rebalance too frequently, and you can face unnecessary trading fees and tax implications that can erode your holdings. Rebalance too little, and you can face significant risks. So, just when should you rebalance your portfolio?

There really is no hard-and-fast rule, and there are in fact occasions when rebalancing is perhaps not even necessary (such as when you believe specific investments will continue to perform well and are worth the additional risk). However, you should make it a habit to review your investments periodically (at least once a year) to determine if rebalancing is needed.

You can also set markers as a trigger to review your investments. For example, some investors set time points—often quarterly or annually—to review their investments. Others set specific asset allocation thresholds (e.g., when an asset class, such as bonds, veers a certain percentage off the initial allocation percentage). Finally, you can also trigger rebalancing as your goals or risk tolerance change.

In sum: why rebalancing your portfolio is important

Successfully executing a long-term investment strategy requires sustained discipline. With this in mind, a periodic review of your asset allocations will help you stick to your investment objectives while maintaining your desired tolerance for risk.

Want to know if your investments need to be rebalanced? Get a complimentary portfolio review and risk assessment today from one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transactions costs and does not assure a profit or protect against a loss.  Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.