Every journey begins with a single step. If you’re new to investing, the most important thing is simply to get started.
- Enroll in your employer’s 401(k).
- Open an IRA and invest in an index fund or exchange-traded fund (ETF).
- Even easier, open an automatically-managed investment account—these companies will handle almost everything for you.
If we were to compare investments to cars, a great investment portfolio would be like a base-model Toyota Camry or Honda Civic. Boring? Perhaps. But it gets the job done, requires very little maintenance, and doesn’t cost a lot.
But even the most reliable car needs its oil changed regularly and will, occasionally, cough up a part that you’ll have to replace.
The same is true of even the best-designed passive-investment portfolios.
Every now and then you might recognize a “bad part”: an investment that no longer meets your goals or you should never have owned to begin with. And, once a year, you’ll need to change your portfolio’s oil, so to speak. This process is called rebalancing.
Who needs to rebalance?
Most investors who own stocks, bonds, mutual funds, or ETFs in any combination of retirement or taxable accounts.
Who does not need to rebalance?
You may not need to worry about rebalancing your portfolio if:
- All of your investments are held within a target date fund or another fund that automatically rebalances.
- All of your investments are within an automatically-managed investment account such as Betterment and Wealthfront.
- You have a financial advisor who manages your investments for you.
Why do you need to rebalance?
A good investment portfolio is diversified among types of investments called asset classes. These include the largest classes of stocks, bonds, cash, real estate, and alternatives like precious metals.
Going further, it’s also beneficial to diversify within each asset class. For example, the average investor wouldn’t want to own only US technology stocks; the safer bet would be to own a mix of domestic and international stocks across many different sectors.
If you’re already invested in mutual funds or ETFs, you already benefit from some diversification. But ensuring the funds you own provide the right allocation of asset classes and foreign vs domestic investments may still be up to you.
How do you rebalance your portfolio?
There are three steps to rebalancing:
- Review your ideal asset allocation.
- Determine your portfolio’s current allocation.
- Buy and sell shares to rebalance your portfolio.
Let’s look at each step in detail.
1. Review your ideal asset allocation
Your ideal asset allocation—the right mix of stocks, bonds, and other asset classes in which to invest your retirement money—is a personal decision. There are guidelines that can help you determine asset allocation, including a very simple rule in which you subtract your age from 100 to arrive at the percentage of stocks you should own (e.g., a 30-year-old should own 70% stocks). These are controversial, however, and I would agree that they’re overly simplistic.
Choosing the right asset allocation involves weighing not only how long you have to invest but, perhaps more importantly, your appetite for risk.
Vanguard offers an 11-question survey that may be useful. It asks some behavioral questions about how you would react to market losses, as well as questions that speak to your investing experience.
Taking the survey, I ended up with an allocation of 80% stocks and 20% bonds. I just turned 35, so this is slightly more aggressive than the simple 100 minus age result of 75% stocks. That’s because my answers suggested I still have a very long time to invest and I’m fairly comfortable with riskier investments that stand to yield larger returns.
When I answered the same survey more conservatively, Vanguard returned an ideal allocation of 50% stocks and 50% bonds. The lesson? Choosing your asset allocation has as much, if not more, to do with your risk tolerance as it does with your age.
A good rule of thumb is this: If you tend to panic during market declines, such as the last month, or if you’ve ever sold losing investments that you planned to hold for a long time, you should consider a more conservative asset allocation, regardless of your age.
Important! For the purpose of this article, we’ll discuss asset allocations that are appropriate for younger investors who are still in the accumulation phase. That is, you’re earning money and investing more each and every year. Asset allocation gets more complicated (and critical, to some degree) once you’re retired and relying on your investments for income.
That said, the best allocation for your accumulation phase is the allocation that will allow you to leave your investments alone for 10 years or more and sleep at night.
2. Determine your portfolio’s current allocation
Once you know your ideal asset allocation, it’s time to figure out where your investments currently stand. Most investment accounts will include this information as part of their online dashboard. Here’s a screenshot of how it looks at Vanguard:
That’s useful if your investments are all in one place. But if you have, say, a 401(k) through work and an IRA on your own, you’ll need to determine the allocation of your entire portfolio.
One helpful tool for this are Empower, previously Personal Capital. You can link all your accounts and track your portfolio in one place with easy-to-understand visuals. Empower is able to offer this tool and other powerful calculators for free because they also offer a paid wealth management service for a fee.
If you want to determine your allocation on your own, I recommend a simple spreadsheet like this one.
If you invest in mutual funds, you’ll need to research the funds’ investment holdings, which can be found in the funds’ prospectuses or via a research site like Morningstar.
Whether you use a spreadsheet or an app, you’ll arrive at a difference between your existing allocation and your ideal. In the above example, this investor has 10% too much in bonds, 5% too much in other and is 15% under in stocks.
3. Buy and sell shares to balance your portfolio
This is where things get complicated, and one of the aforementioned apps can come in handy.
Basically, in order to bring your asset allocation in alignment with your idea, you’ll need to sell off investments that are overweighted in assets you want to reduce and buy investments in asset classes you want to increase.
To use a simple example, let’s say you own two index funds, both with balances of $5,000.
Vanguard Total Stock Market Fund—$5,000
Vanguard Total Bond Market Fund—$5,000
Total: $10,000 (100%)
So you have a 50/50 asset allocation. You’ve decided you want to be more aggressive and increase your asset allocation to 80% stocks and 20% bonds. To do that, you need to sell $3,000 of the Total Bond Market Fund and buy $3,000 of the Total Stock Market Fund, so that your resulting portfolio looks like this:
Vanguard Total Stock Market Fund—$8,000 (80%)
Vanguard Total Bond Market Fund—$2,000 (20%)
Total: $10,000 (100%)
What if you’re buying shares?
Often times, you might decide to rebalance your portfolio at the same time you’re going to purchase more shares. In the above example, let’s say you want to arrive at an 80/20 allocation and are intending on investing an additional $2,000.
Your total portfolio will now be worth $12,000 and you’ll want it to include $9,600 in stocks and $2,400 in bonds. In this case, you would sell $2,600 of the bond fund, add it to the cash you currently want to invest and buy $4,600 in the stock fund. Your portfolio will then look like this:
Vanguard Total Stock Market Fund—$9,600 (80%)
Vanguard Total Bond Market Fund—$2,400 (20%)
Total: $12,000 (100%)
How often should you rebalance?
For most young, long-term investors, rebalancing once a year should suffice. If you’re just talking about retirement accounts, it doesn’t really matter when you rebalance. Tax season is as good a time as any, especially if you make IRA contributions leading up to the April 15th deadline.
If, however, you own taxable (non-retirement) investment accounts, it’s a good idea to rebalance before the end of the calendar year to take advantage of tax-loss harvesting. Without going into detail here – you can reduce your tax bill when you sell losing investments before the end of the year. If you need to sell an investment to rebalance your portfolio and it’s lost money since you bought it, you can snag a bonus by harvesting the loss for tax reasons.
Consider rebalancing after big market movements
When a market goes up or down by 5% or more, your allocation will likely fall out of balance. So if you want to be more proactive, you might also consider rebalancing your portfolio anytime the markets move dramatically, such as the ups and downs we’ve seen this January.
Rebalancing makes my head hurt, how can I avoid this?
Rebalancing a complicated investment portfolio used to be a tedious exercise that made it attractive to have a financial advisor in your corner. But technology has come to the rescue in the robo-advisor vs financial advisor debate. The powerful free financial product, Empower, can make the task more manageable, for example.
And if you’re still wary, consider one of these best robo-advisors, or what I like to call automatically-managed investment accounts, for your IRA. These include Wealthfront and Acorns. With these companies, you set your asset allocation and they do the rest for you – automatically rebalancing and harvesting losses while you get on with your life.
Keep in mind, however, that a robo-advisor can’t help with your 401(k) or other employer-sponsored retirement account. If you’re the hands-off type, choose a target-date mutual fund in your 401k. These funds are pegged to the date you expect to retire and will automatically rebalance over time.
Rebalancing is an important part of long-term investing. Once a year, you should compare your investment portfolio to your ideal asset allocation – the right mix of stocks, bonds, cash, or other investments for your investment goals. Then make changes by selling and buying shares of investments to realign your portfolio to your desired target.
Free tools like Empower can help. But if this sounds like something you never want to worry about, consider working with a financial advisor or sticking to a robo-advisor like Wealthfront, Betterment, or Acorns.