Rebalancing your portfolio


Allocating the right mix of investments in your portfolio is a major part of effective financial planning. But since the values of your investments are constantly fluctuating in response to market conditions, you’ll need to take a step back once in a while to make sure your assets are still allocated the way you intended.

If your investment mix has changed, you may want to rebalance your holdings. If you don’t, you could easily drift into a portfolio allocation that exposes you to greater investment risk than you’re comfortable with, or one that is likely to provide a significantly lower return than you had anticipated.

Riding the financial market rollercoaster

One result of the normal ups and downs of the financial markets is that, at any given point, your actual portfolio allocation may be significantly different from the one you started with — and that you prefer to maintain.

That’s because market performance increases or decreases the value of individual investments all the time. This, in turn, affects the overall value of the asset classes to which these investments belong. For example, if one asset class increases in value more than other asset classes, it will, over time, make up a greater percentage of your portfolio. And, conversely, if an asset class underperforms, it may make up a smaller portion of your portfolio than you expected.

It could happen to you

As an example of how your portfolio allocation can drift from the one you intended, consider a $100,000 portfolio with 60% allocated to equities, 30% to long-term debt securities, and 10% to cash.

Now suppose that equities overall provided a one-year return at a higher than average rate — say 20% rather than 10% — at the same time that long-term debt returned 2.5%, rather than the historical average of about 6%, and cash returned a lower than average 1%. These varying rates of returns will affect the balance of the three asset classes in your portfolio.

What began as a 60-30-10 relationship is now 64-27-9. While that shift isn’t particularly dramatic, another year of similar returns could increase your equity allocation to 67% while reducing debt to 25% and cash to less than 8%.

If you’ve experienced similar portfolio shifts and your investing goals and style have remained the same, you may want to think about rebalancing your portfolio.

Keeping your balance

To avoid any surprises, it’s smart to review your portfolio from time to time, and adjust your holdings to bring the allocation back in line with the model you’ve selected.

To do that, you can choose to sell off a portion of the asset class (or classes) that have increased the most in value and reinvest your profits in the lagging class or classes. Another method is to change the way your new investment money is allocated, putting more money into the lagging asset class until the allocation mix has returned to the balance you intended. As an alternative, you can put extra money into the lagging class to correct the imbalance.

Knowing when to rebalance

Some investment advisers suggest rebalancing your allocation once a year as part of an annual reassessment of your financial plan. But there’s no official timetable for rebalancing, and the more time you have to attain a particular financial goal, the less reason there may be for frequent rebalancing. Remember, the more frequently you buy and sell, the higher your transaction fees are likely to be, whether you’re rebalancing a taxable or a tax-deferred account such as an employer-sponsored 401(k) plan.

Alternatively, you might want to sell off holdings in your portfolio’s strongest asset class when that class exceeds your target allocation by a specific percentage — say 10% or 15% — and reinvest the money in the lagging class. While it may seem counterintuitive to shed the strongest performers, what you’re doing in effect is selling high and buying low. It’s similar to selling shares of a stock that has increased in value to buy a lower-priced stock with growth potential. It also positions you to benefit from gains in the currently lagging asset class if it gains momentum later in the market cycle.

Tax implications

When selling investments to keep your asset allocation in balance, you need to consider the tax consequences. For example, if you realize a capital gain in a taxable account from selling an investment that has increased in value, you’ll owe tax on that gain when you file your income tax return for the year. However, you may be able to offset the gain with capital losses.

One way to reduce the tax you owe is to sell off only those investments you have owned for more than a year. Any profit, in that case, is considered a long-term gain and is taxed at the long-term capital gains rate. In 2017, your capital gains rate is zero if you’re in the 10 % or 15% tax bracket. If you’re in the 25% through 35% bracket, your long-term gains will be taxed at 15%, and at 20% if you’re in the 39.6% bracket.

Another way to save on taxes is to sell the weakest performers in the overperforming asset class. Getting rid of them may produce fewer gains and so minimize the tax due.

What you don’t want to do is lose sight of the overriding goal of rebalancing, which is to keep your investment strategy on track.

 

 

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