By Adam K. Wright, CFA®, CFP®
As you learn how to become a better investor, you’ll likely come across some key tenets of successful investing: buy when prices are low, diversify your portfolio, keep your investment costs low, don’t actively trade in and out of stocks, and definitely don’t try to guess what will happen next in the economy and stock market.
By following those key lessons, you will hopefully come to the conclusion that having a well-diversified portfolio that aligns with your financial goals and risk tolerance is the best way to invest. However, simply setting up a diversified portfolio is only the first step. Periodically checking in to review how risk has shifted is important. From time to time you will need to maintain your portfolio by using a strategy called rebalancing. Essentially, rebalancing helps you do the right thing at the right time, like selling high and buying low.
In this article, we’ll discuss what rebalancing is, why it’s necessary, how it can help you, and key ways to use this strategy.
If Not Rebalanced, Your Investments Will Get Stock-Heavy
When you first set up your investment portfolio, you carefully selected a mix of assets such as stocks, bonds, and possibly other asset classes, based on your financial goals, risk tolerance, and investment horizon. However, over time, the performance of each asset class, and each investment inside those asset classes, may differ, and the overall value of some assets may increase more than others. While there is no guarantee of what will happen in the future, stocks have historically outperformed bonds, which means if you don’t touch your investments after setting them up, the stocks will grow in their allocation while the bonds will fall.
As a result, your portfolio may become imbalanced, and your investments may be more heavily weighted toward one asset class (like stocks) than you initially intended. For instance, suppose you initially allocated 50% of your portfolio to stocks and 50% to bonds. Using historical returns, after 15 years, your portfolio will comprise almost 70% in stocks and only 30% in bonds. If you don’t change anything for 30 years, stocks will comprise 83.5% and bonds only 16.5%.
What’s the issue with that, exactly? That leads to our next point.
Rebalancing Lowers Your Risk and Keeps Alignment With Your Goals
Rebalancing your investment portfolio regularly can offer several benefits that can help you pursue your financial goals. Firstly, it helps you maintain the desired asset allocation that aligns with your investment goals and risk tolerance. By adjusting your portfolio periodically, you can help keep your investments balanced, and your asset allocation does not deviate significantly from your original plan. This can reduce your exposure to market risk, provide better downside protection during market downturns, and potentially lead to higher returns in the long run.
Secondly, rebalancing forces you to sell assets that have performed well and buy those that have underperformed. In other words, buy low and sell high.
Lastly, rebalancing can help you avoid emotional investing decisions, such as panic selling during a market crash or holding on to assets that have performed well but are now overvalued. By taking a disciplined approach to rebalancing, you can stay focused on your long-term investment plan and avoid making decisions based on short-term market movements.
The Risks of Not Rebalancing Before Retirement
As you approach retirement, the benefits of rebalancing become even more important. As you transition from a steady work paycheck to creating your own retirement paycheck, you will want your portfolio properly structured to create the retirement income you need. To do that, it becomes more necessary to own a healthy allocation of less volatile investments (like bonds). As shown above, without rebalancing, your retirement portfolio can become very stock-heavy, making the effects of a market drop more painful. Rebalancing your retirement portfolio helps maintain the balance needed to create a stable retirement income stream.
Assets like bonds and cash will hopefully experience less volatile moves, helping you create a steady stream of retirement income. At the same time, this can allow your stocks time to recover, at which point you can then monitor and potentially rebalance your account to get back to your original allocation.
How (and When) to Rebalance
Now that you understand the importance of rebalancing, it’s time to discuss how to actually implement it. Like many areas of personal finance, there are different ways to achieve the same goal. One method is to periodically rebalance every month, quarter, or year, on some predetermined time schedule. This is a simple approach that keeps your portfolio continually rebalanced.
However, it doesn’t account for whether your investments have actually changed. Because of that, we prefer a different approach, which is tied to how much your investments have changed over time. At our firm, we rebalance accounts once they have “drifted” either above or below a certain threshold. Specifically, let’s say we want stocks to be at 50% of the portfolio. Once they go above 56.25%, or below 43.75%, we rebalance the portfolio back to the original weight. Known as a 12.5% tolerance band, this allows for an asset class to move within that range before it needs to be rebalanced.
This is a powerful technique as it permits an investment or asset class to outperform the others, and potentially increase the returns of the overall portfolio. Once it’s increased beyond the band, you then sell some of the shares, and buy more of an asset or investment that has performed poorly, in the hopes that the poorly performing investment will rebound.
Historically, doing this has proven to be a positive on the long-term returns of your portfolio.
Are You Optimizing Your Investment Portfolio?
If you aren’t rebalancing your portfolio, now is the time to start. If you aren’t sure you want to do this on your own, the team at Wright Associates would love to help. To help keep your investments properly structured and rebalanced for your retirement, you can schedule a complimentary phone call to get started today.
Adam Wright is a CERTIFIED FINANCIAL PLANNER™ professional at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.
Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.