The Balancing Act: Are You Taking Too Much Risk With Your Money?

Portfolio rebalancing is simply the buying and selling investments in a portfolio to make the current asset allocation match the original asset allocation. Asset allocation is the mix and weightings of investments that make up your portfolio.

The two primary asset classes are equities (stocks) and fixed income (bonds). Generally, stocks are more volatile, and are therefore considered more risky assets than bonds. Over the long term, however, stocks have shown tendency to outperform bonds. So a younger person with more years ahead of him to recover from losses may choose a portfolio more laden with stocks, while an older person may weight her portfolio towards bonds. (You can monitor your financial goals like building good credit for free on Credit.com.)

When Should You Rebalance?

Throughout the year, the initial weighting of your chosen allocation can change due to unequal market performance among asset classes. When this happens, your portfolio may no longer match your appetite for risk.

Let’s assume that a person started out with a portfolio of 60% stocks and 40% bonds. If equities outperformed bonds, then at the end of the year, the allocation may end up with 70% stocks and 30% bonds. When this happens, it is time to consider rebalancing the portfolio back to the original allocation. Another reason to rebalance is if your investment goals or tolerance for risk has changed from the time you created the portfolio.

Rebalancing is counterintuitive. It forces us to sell better performing asset classes and buy underperforming asset classes. Instinctively, we want to keep over-performing assets in our portfolio and sell under-performing ones. Keep in mind, however, that one of the primary goals of investing is to buy low and sell high. Rebalancing is an unemotional process that forces the investor to buy asset classes when they are low and sell when they are high. While it cannot guarantee a profit, consistent rebalancing does tend to lower overall portfolio risk over the long term.

You should rebalance your portfolio at least annually or when an asset class is 5% or more out of balance. More frequent rebalancing can reduce portfolio volatility even further (but also can limit returns). Some investment plans can be set up to automatically rebalance your portfolio at predetermined time frames.

Avoiding Tax Consequences

A very important consideration in determining when and how to rebalance is income taxation. If you are rebalancing within your IRA or your 401(k), then this is not a concern since all taxation is deferred until the money is actually withdrawn from the plan. Conversely, a taxable account will necessitate that you consider the effects of taxation on your transactions. Generally, if you sell an investment with a gain, you will have to pay income tax on any profit. If the investment was held for more than one year, the income tax rate will generally be at the lower capital gains rates. Still, paying any income tax on investment performance will lower your after-tax investment return.

There are a few ways to minimize the effects of taxation when rebalancing. If you have both taxable and tax-deferred portfolios, you can implement the rebalancing as if the two accounts were one. Consider only selling assets inside the tax-deferred account so that your overall asset allocation between both accounts will match your tolerance for risk. This will probably make each of the individual accounts look skewed when considered separately, but when viewed together, you can maintain a balanced portfolio with minimal taxation.

If you only have a taxable account, you can try to match the sale of investments with gains to the sale of the assets with losses. If you can do this, then the gains could be offset by the losses, thereby reducing or even eliminating any taxable gain. Matching capital gains with capital losses can be complicated, so you may want to secure the help of a professional before you place any trades. (Full Disclosure: I am a Certified Financial Planner who advises clients on investment decisions.)

Another option is to allocate all future investment contributions to the underweighted asset classes in order to increase their value while leaving the over-performing assets alone. It will take a bit longer to balance the portfolio, but you will do it without the burden of taxation from selling or the complication of capital gains and losses.

While I have only mentioned stocks and bonds, rebalancing can also include sub-asset classes, like small company stocks, international stocks, emerging markets and high-yield bonds. If you have allocations to sub-asset classes, you should also consider their relative allocation when rebalancing.