How To Rebalance Your Portfolio
Effective long-term investing is pretty straightforward. Buy low-cost broad market index funds and hold them for as long as possible. However, it is not completely hands-off. There is one component that needs periodic tune-up and maintenance. Investment pros call this portfolio rebalancing. So the big question is how do we go about doing this?
Unfortunately, just like there is no one way to live life, there is no one foolproof “one-size-fits-all” method for rebalancing your portfolio. Each investor must choose a rebalancing method that is appropriate for them at their specific life stage.
So in this post, we are going to review some of the most common ways to rebalance your portfolio. We will also cover some key considerations given that rebalancing can create ripple consequences we need to be aware of.
Portfolio Rebalance 101
Rebalancing in its simplest form is the act of bringing our portfolio back to our target asset allocation. Most often this is required after market forces or life events have changed the percentages of our various asset classes and segments of those classes. And we want to rebalance our portfolio because we want to control risk.
Holding an S&P 500 index fund or a total market index fund is a smart investing move, however, stocks represent just one asset category against other types of asset categories out there. Bonds, Real Estate, Commodities, and even Cash represent different asset classes. In order to minimize risk, especially as we get older, we want other asset classes within our investment portfolio to help offset or augment our equity holdings.
For example, you might want bonds to help smooth your stock volatility. Or you might want international funds to gain exposure to the market outside the United States. And not only do you want these other asset classes in your portfolio, but you also want to adjust the amount you have of each asset class as you get closer to your retirement age. Making your portfolio more conservative versus aggressive using different asset classes.
A general rule of thumb is that as you get closer to your retirement age, you want to hold more stable assets like bonds and cash versus stocks in your portfolio. And this is where investing becomes a lot more of an art than a science. And especially because past returns don’t guarantee future returns, you as an individual investor will need to make adjustments to your portfolio based on your risk tolerance and your comfort level with different types of assets.
Therefore rebalancing brings our portfolio back to the level of risk that we determined was appropriate for us and that we were comfortable with when we first established our asset allocation plan.
For example, let’s say that I am at a stage where I want to target 70% equity and 30% bond. But in the past few years, the equities market has done really well, so now my portfolio is 90% equity and 10% bond. Now equities are a much larger percentage of our portfolio than desired and bonds make up a smaller percentage than called for in our original asset allocation plan.
Asset allocation plan that was established with our long-term goals, retirement timeline, and risk tolerance into consideration. So whenever our portfolio that started out as balanced can become lopsided, rebalancing our portfolio can bring things back into alignment.
Method #1 - Sell & Redirect
Simply, sell portions of high-performing assets and redirect the money toward asset classes that you want to lean into.
For example, let's say you follow a two-fund strategy and you own two simple index funds in your portfolio of $100,000. Based on your risk tolerance you feel a 70 to 30% asset allocation works for you. So you invest $70,000 in Vanguard Total Stock Market Index Fund, the VTSAX, and $30,000 in Vanguard Total Bond Market Index Fund, the VBTLX.
Now after many years, you decide to check your account and you notice that your VTSAX account has more than doubled in value to $160,000 while your bond fund only increased to $40,000. Your portfolio has skewed to an 80 to 20% asset allocation from its original 70 to 30% asset allocation.
If you want to bring it back to its original asset allocation, what you can do is sell a bit of your VTSAX and purchase VBTLX. In this example, $20,000. Sell $20,000 of VTSAX and purchase $20,000 of VBTLX. This will bring your overall asset allocation back to 70/30 with $140,000 in VTSAX and now $60,000 in VBTLX.
Now although this is one of the most straightforward ways to handle rebalancing, I do want to share with you that other methods are given there could be better options.
Method #2 - Buy More
You are essentially purchasing new investments in the underweighted asset classes until things balance out. Going back to our earlier example where our portfolio had skewed to 80 to 20 from its original 70 to 30, instead of selling VTSAX and buying more VBTLX, what we can do is just buy more VBTLX.
Let’s take a look at an example. Let’s say again that our original $70,000 in VTSAX has appreciated to $160,000 and our $30,000 in VBTLX has appreciated to $40,000. Instead of selling part of our $160,000 what we can do is buy more VBTLX until we get back to our 70/30 target asset allocation.
In this example, that would come out to approximately $30,000 ($28,571) more invested in VBTLX. And if we’ve been adhering to dollar cost averaging, where we’ve been contributing a set amount into each account at regular intervals, we can just adjust the contribution to direct 100% of investments into VBTLX until we reach our target asset allocation.
The benefit of this approach of buying more of the underweighted class in comparison to selling and redirecting is that we mitigate tax consequences.
If we are rebalancing a tax-advantaged retirement account, like an individual retirement account (IRA) or 401(k), we don’t need to worry about tax consequences because we don’t realize taxable gains within those accounts.
However, whenever we sell investments from a taxable account we need to understand that there could be capital gains tax.
Now there are ways to minimize taxes when rebalancing such as tax loss harvesting. A strategy where we sell investments that have decreased in value and then use the losses to decrease our income taxes. However there are strict rules we need to follow as well as limitations, so we should consider all that when rebalancing.
Method #3 - Withdraw First
Just think the complete opposite of method two. Instead of buying more of the asset class you want to increase, you spend first the asset class you want to decrease. You are essentially using both voluntary and/or required distributions from your tax-deferred account to help rebalance your portfolio.
Going back to our earlier example when our portfolio had skewed to 80 to 20, $160,000 in VTSAX and $40,000 in VBTLX, we can just withdraw from VTSAX until we reach our target asset allocation.
If our VBTLX amount remained flat at $40,000, then when we spent down our VTSAX fund to approximately $90,000 ($93,293), we would be back to the 70 to 30% asset allocation.
Now I know I covered a lot of technical terms and numbers here. So if all these talks of rebalancing and asset allocation are giving you a headache, no worries. Let me share with you one more method that could alleviate some of that headache of yours.
Method #4 - Don’t Rebalance
Now you must be asking how is that even possible. Black rebalancing magic? Unfortunately no. One is by having a super simple investing and asset allocation strategy. My favorite is the 2-fund strategy that I alluded to earlier in this post. When you have a 2-fund strategy, as the name implies you only have two funds in your portfolio. An equities fund and a bond fund.
And when you are in your wealth accumulation phase, a phase of life is when we are in our 20s, 30s, or even 40s, you can get away with having literally just one equities fund like the Vanguard Total Stock Market Index Fund, the VTSAX.
Yes, 100% of stocks is considered a very aggressive investment allocation. However, when you are young you should be. You have decades ahead to invest and market ups and downs should just be noise to you. You should be excited for market dips during this phase because they are great buying opportunities to scoop up more shares of VTSAX at a lower price.
And the nice aspect of this strategy is that you don’t even have to think about rebalancing until you get closer to your retirement age when you will start adding a bit of bond. Now if that is even too complicated for you I have another recommendation that can alleviate your pains of rebalancing.
Method #5 - Target Date Fund
They are sometimes called Target Retirement Funds or sometimes Lifecycle Funds based on the investment firm, but the premise is the same.
Unlike a do-it-yourself portfolio, a target date fund will rebalance the asset allocation of the portfolio automatically as you get closer to your retirement age.
The basic investing philosophy is the same as a DIY portfolio, but it makes investing even easier. You can think of it as the poor man’s financial advisor without all the downsides of actually having a financial advisor.
If you want to make good investment decisions, but don’t have any desire to learn about investment strategy or portfolio rebalancing, this one fund would literally be all you need for the rest of your life.
It has automatic built-in-diversification because it holds low-cost broad market index funds, and it automatically adjusts asset allocation as you get closer to your retirement age.
As I mentioned earlier, a general rule of thumb is that as you get closer to your retirement age, you want to hold more stable assets like bonds and cash versus stocks in your portfolio. A target retirement fund does this for you automatically, making your portfolio more conservative versus aggressive using different asset classes.
As an example, assuming I want to retire when I’m in my 60s, my Vanguard-specific Target Retirement fund would be Vanguard Target Retirement 2045 Fund, also known as VTIVX.
Few Considerations
Alright, now that we’ve covered the why and how of rebalancing, let’s look at some other items we want to consider when we’re rebalancing:
Tax Deferred - One is to rebalance your tax-deferred account first whenever possible since there are no tax consequences. As I mentioned earlier, if you’re rebalancing a tax-advantaged retirement account, you don’t need to worry about tax consequences because you don’t realize taxable gains within those accounts. However, selling investments from a taxable account could put you on the hook for capital gains tax.
Minimize Taxes - Two is to minimize taxes. You can do this by using tax-loss harvesting in your taxable account as part of your rebalancing strategy. Or better yet, avoid capital gains taxes by using new cash contributions to purchase assets that bring your allocation into balance.
Once A Year - Three is to assess your target asset allocation at most once a year. Some say you should do it more frequently, however, according to research from Vanguard, there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not markedly different. And I feel like checking our investments too frequently might actually do more harm than good to achieving our long-term goals.
Simplify - Fourth if you want a super simple solution, really consider simplifying your investment strategy by either pursuing a 2-fund portfolio or a Target Date Fund that automatically handles the rebalancing chore for you. If you like to learn more about Target Date Funds, sometimes called Target Retirement Funds to really simplify your investment check out my post here.
