There are certain fundamentals of investing—among them, building a portfolio and portfolio rebalancing. Armed with knowledge of these basics, an investor can better tailor their investments to their financial goals.
When it comes to building a portfolio, diversification is key. With a diversified portfolio—in which an investor has money in a range of different assets—there is a risk of loss. But while there can be ups and downs, in the long run, a diversified portfolio on average has a much higher return than putting money in a bank savings account.
There are many ways to diversify: A simple off-the-shelf portfolio or mutual fund, which is a diversified collection of stocks, bonds, securities, and/or assets, is one simple approach. But once an investor has put together their portfolio, they’ll be faced with the question of how often to rebalance that portfolio.
Rebalancing a portfolio can take place on two different timetables: either at set time points (quarterly, monthly, annually) or at set allocation points (when the assets change a certain amount). Here’s what to know to execute this important investment strategy.
What is Portfolio Rebalancing?
Portfolio rebalancing is just another way to describe adjusting your investments. It means an investor changes the asset allocation of their portfolio to return to their desired portfolio make-up.
The allocation of investments in an investor’s portfolio—a combination of assets like stocks, bonds, mutual funds, cryptocurrency, commodities, and real estate—should be made with individual risk tolerance and financial goals in mind.
A conservative investor might go for a less risky portfolio. One who is many years away from retiring and won’t need to pull their money out of retirement investments soon might be comfortable with a bit more risk.
Over time, however, the different assets have different returns/losses and so the amount of each asset changes—one stock or fund might have such high returns it eventually grows to be a larger portion of the portfolio than an investor wants.
For example, if you’re aiming to have 70% stocks and stock prices go up drastically over a quarter, you might end up with 80% of your portfolio’s value being held in stocks. That’s when it could be time to rebalance.
Why You Should Rebalance Your Portfolio
It might be tempting to think that if a specific asset has outperformed, then one should keep a higher portion of their portfolio in that asset—and not rebalance.
But it’s important to remember that the asset allocation of portfolios is based on a risk-to-return tolerance. A diversified portfolio spreads investments out across different assets so that if one asset goes down an investor has the opportunity to balance it out.
Portfolio rebalancing also gives investors a good opportunity to review their portfolio and the various funds or assets they’re invested in. In addition to simply looking at asset classes, investors can look at specific funds. If one fund now makes up a larger portion of the investments, an investor might decide to adjust.
One caveat: Some funds, such as target date funds, are designed to change their asset makeup over time. These funds still need to be rebalanced to accurately reflect the desired asset allocation at any specific point, but the fact that they typically shift, over time, to a less risky investment strategy isn’t necessarily something that needs to be adjusted—after all that shift is the point of a target date fund.
How Often Do You Need to Rebalance Your Portfolio?
Portfolios can be rebalanced at set time points (quarterly, monthly, annually) or at set allocation points (when the assets change a certain amount). Rebalancing by set asset targets is a good way to approach portfolio rebalancing since markets can change more in some time periods than in others. A standard rule of thumb is to rebalance when an asset allocation changes more than 5%—ie. if a certain subset of stocks changes from 15% of the portfolio to 20%.
Multiple studies have correlated the frequency of checking in on one’s portfolio with market losses over time—because the more often an investor checks it, the more often they stress about small ups and downs, and then more likely they are to pull money out when they shouldn’t.
Another way to know when to rebalance your portfolio is to set specific times to do it—i.e., every quarter or at the start of the year. One study from Vanguard found there was no meaningful difference in risk-adjusted returns if the portfolio was rebalanced monthly, quarterly or annually—especially if you take into account the costs of doing it yourself with transaction fees.
For a lot of people, it makes sense to use the end of the year as a time to examine their financial investments and look at any potential changes coming in the new year.
The downside of rebalancing at set calendar appointments is that you risk overdoing it. Just because it’s on your schedule doesn’t mean you necessarily have to rebalance if the asset allocation hasn’t fallen outside of your set range.
How often to rebalance a portfolio also depends on how involved you want to be and what stage of life you’re in—maybe those closer to retirement will want to rebalance more frequently as a risk avoidance strategy.
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How to Rebalance Your Portfolio
An investor can do portfolio rebalancing themselves—sell some assets, buy up some others. Most online brokerages allow investors to buy and sell on their own for minimal fees.
The first step to know exactly where you stand already: an investor will want to review their whole portfolio, and get a sense of their allocations to different sectors (stocks, stocks from different countries, bonds, exchange-traded funds, etc). But this knowledge will only be useful if one already knows what their asset allocation should be. It helps to review your allocation from when you started investing or reference prior investment or allocation goals. This is known as your “ideal asset allocation.”
In general, an investor who plans to rebalance their portfolio themselves should keep track of quarterly and monthly statements from brokerage and retirement accounts and have a sense of your overall allocation and amount of money invested. Once they have a handle on how to rebalance, they’ll need to buy and sell shares or securities in order to maintain their ideal asset allocation.
But there can be a fine line between prudent rebalancing and harmful overtrading. While lots of people like to be involved and actively manage their portfolio, the downside is that active trading can obviously cause you to buy and sell at the wrong time. Furthermore, buying and selling shares often incurs fees, which eats into the gains or any strategy an investor is trying to execute by rebalancing.
In a 2014 study from JP Morgan found that if investors had stayed fully invested in the S&P 500 (one of the most commonly used weighted market indexes) from 1993 to 2013, then they would have had a 9.2% annual return—but if they missed even just a handful of the biggest days because of trades then that return drops nearly 4%.
All that is to say too much active involvement and trading could have a detrimental effect. There is an alternative: Many investment products will do this automatically, including SoFi’s automated investing, which rebalances quarterly by selling assets whose allocation has gone up by 5 percentage points.
Different Types of Portfolio Rebalancing
There are several ways to rebalance investments for different goals and different stages of one’s investing life.
We’ll look at three major ones: rebalancing to ensure investments are still diversified, using so-called “smart beta” strategies, and rebalancing retirement accounts.
Rebalancing for Diversification
The most basic form of rebalancing is maintaining diversification of a portfolio. The strategy seeks to minimize risk while maximizing return. But over time, a portfolio can become less diverse, as different assets have different rates of return and can take up more and more of your invested money. This is where rebalancing comes in.
Here’s a simple example. Let’s say you invest $100,000: $60,000 in stocks and $40,000 in bonds. After three months, the stock market has grown 8%, while the bond market has advanced 1.5%. Now your portfolio has $64,800 worth of stocks and $40,600 worth of bonds; your stocks are about 61.5% of your portfolio and your bonds are 38.5%. In this case you would want to sell enough stocks to get back down to 60% of $105,400 (the portfolio’s new value) or $63,200, and buy bonds to get the allocation up to 40%, or $42,200.
In the real world, an investor would likely have more detailed and sophisticated allocation goals, but this example illustrates how some simple arithmetic can guide rebalancing.
Smart Beta Rebalancing
Another approach to asset allocation is known as “smart beta,” a strategy that combines index investing with more discretionary strategies.
With index investing, an investor buys what is essentially a list of component stocks in a benchmark index (like the whole S&P 500) in order to track the benchmark’s performance. The stocks are weighted based on their market capitalization. Index investing is considered a passive strategy, and it’s typically done through the purchase of index mutual funds and exchange-traded funds (ETFs), whose managers handle the rebalancing of holdings when market caps shifts.
Smart beta is rules-based, like index investing. But instead of market cap, its strategies consider volatility, quality, liquidity, size, value, and momentum when weighting stocks. In this way, smart beta adds an element of active investing to passive investing. And as with index investing, investors can employ a smart beta strategy by buying smart beta mutual funds or ETFs.
Rebalancing Retirement Accounts
In many cases, retirement savings are in investment accounts. That’s why it’s especially important for investors to be aware of the allocation and balances of their retirement accounts, whether they’re 401(k)s, IRAs, or a combination thereof.
The principles at play are similar to any type of portfolio rebalancing, but there’s a particular set of considerations for age. Generally, retirement accounts rebalance over time not just to a target allocation for a given year, but a changing allocation to get more conservative as the investor gets closer to retirement. Target date funds typically work by rebalancing over time from stocks to bonds as their fundholders get closer to retirement.
For investors to stay on top of this themselves, they’ll need to have an idea of how they want their investments allocated in each year as they get closer to retirement, and then use quarterly or annual rebalancing to buy and sell securities to hit those allocation targets.
Rebalancing an investment portfolio can help investors stay on track to meet their long-term goals. By ensuring that there is a steady mix—or diversification—of assets in their portfolio, they can stay on top of their investments in a way that works with their risk tolerance and their financial needs.
There are ways investors can rebalance their portfolios on their own—and different strategies they can use.
But for investors who don’t want the task of rebalancing their portfolio, there are other options. For example, the SoFi Invest® online brokerage offers automated investing; you can start with just $1.
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