Now that we have your portfolio up and running, the rest comes down to three things: contributing consistently, maintaining your portfolio, and staying the course. We are going to focus here on maintaining your portfolio, which largely comes down to one thing: rebalancing. We have already touched briefly on rebalancing while discussing how to plan your asset location, but we’re going to dive into exactly what it is—and exactly how to do it.
What is Rebalancing?
As your portfolio grows, you will find that the asset classes that comprise it will grow (or sometimes drop) in value at different rates. Over time, this can mean that your actual asset allocation may begin to stray from your target asset allocation. Small deviations from your target allocation are not very significant, but as the gap begins to widen, it can make a substantial impact on your portfolio. The act of bringing your current asset allocation back in line with your target asset allocation is called rebalancing.
Over time, your actual asset allocation may begin to stray from your target asset allocation. The act of bringing your current asset allocation back in line with your target asset allocation is called rebalancing.
Remember that your portfolio’s asset allocation was chosen by you due to its risk and performance characteristics—and how these fit both your situation and you individually as an investor. When your current allocation begins to drift away from your target allocation, this essentially means that your portfolio drifts away from the risk and performance profile you are comfortable with. Thus, the purpose of rebalancing is to ensure that your portfolio always remains near the intersection of risk and performance you are striving for.
How to Rebalance
Rebalancing is something every investor needs to do from time to time, and there are a couple of different ways to accomplish it. The easiest (and perhaps most natural) way is to simply adjust the “mix” of your future contributions. If adjusting through contributions is not enough, it may require making manual adjustments to bring your allocation back in line.
To see how this works, let’s walk through an example using both. Let’s say for the sake of our example that you have chosen the following target asset allocation for your portfolio:
Let’s also say that U.S. stocks have been in a strong bull market (growth market), and as a result, the U.S. stocks component of your portfolio outpaces your other two asset classes (international stocks and bonds). Over time, this means that you end up with your actual allocation looking like this:
Keeping in mind your target asset allocation, where does this leave us? Let’s compare the two.
Let’s unpack what we’re seeing in this one for a moment. The red areas above indicate how much your portfolio is overweighted in U.S. stocks. When I say overweighted, I mean your current allocation compared to your target allocation. In this example, you hold 69% U.S. stocks when your target allocation calls for only 64% U.S. stocks. And this additional 5% eats into your allocation to both international stocks and bonds: as a result, your international stocks allocation is underweighted by 2% (target: 16%, actual: 14%), and your bonds allocation is underweighted by 3% (target: 20%, actual: 17%).
Given this, how exactly do we go about bringing our allocation back in line? Let’s start with the easiest, and most natural: rebalancing through contributions.
Method #1: Rebalancing Through Contributions
This method is quite simple. It involves adjusting the “dials” of your future contributions to offset the imbalance in your current portfolio. Here’s how it works.
In our example, your portfolio is overvalued in U.S. stocks, and undervalued in international stocks as well as bonds. Using this method, we would thus want to simply decrease the amount of your contributions going to U.S. stocks, and commensurately increase your contributions going to both international stocks and bonds. Unless the market is strongly trending in a certain direction, over time this should bring your allocation back in line with your target.
Method #2: Manual Rebalancing
Let’s assume that it doesn’t work. You are unable to make any headway by adjusting your contributions, and as a result, your allocation stays right at 69% U.S. stocks, 14% international stocks, and 17% bonds. You are now in a position where you will need to make manual adjustments to bring your allocation back in line.
What this means is that you would need to sell 5% of your U.S. stock allocation, and use that money to put 2% back into international stocks, and 3% back into bonds. This would put you back at 64% U.S. stocks, 16% international stocks, and 20% bonds—your target.
This is a good time to pause and point out one of the side benefits of rebalancing. Think about what we just did when we manually rebalanced. We sold one asset class that was overvalued in your overall portfolio (U.S. stocks), and we bought two others that were undervalued in it (international stocks and bonds). Because of this, rebalancing increases the likelihood that you will end up selling high and buying low.
…rebalancing increases the likelihood that you will end up selling high and buying low.
And as always, I recommend doing any rebalancing inside a tax-advantaged account if at all possible. If you are left needing to rebalance inside a taxable account, I would strongly advise consulting with your tax professional first, to ensure you are fully aware of the tax implications of any changes.
When to Rebalance
Here’s some good news: you won’t need to rebalance very often—usually once or twice a year should keep you covered. That said, people have different methods that they use to determine the need to rebalance. Here are two of the most popular:
Some investors prefer to simply choose a specific time to rebalance—such as scheduling a rebalance once or twice a year. If you go with this method, choosing a day or two that are easy to remember (such as birthdays, holidays, or a wedding anniversary) may make it easier. Don’t forget to add your rebalance day(s) to your calendar!
Pros & Cons: This approach does not require you to track your portfolio nearly as frequently as the following method, but in times of volatility, it also means that your portfolio could stray quite a bit from your target allocation before your next scheduled rebalance.
Some investors prefer to use a measure of variance from their target asset allocation as a “trigger” to tell them that it’s time to rebalance. This means they allow their current allocation to drift only so far from their target before needing to make adjustments.
For example, I personally use this method, and have my variance bands set to trigger at 5%. What this means is that when one or more of my asset classes get 5% or more off my target allocation, I know it’s time to rebalance.
Look back at our example above. If we’d had our variance bands set to 5%, we would have known that it was time to rebalance, as our U.S. stocks allocation was 5% off from our target.
Pros & Cons: This method requires you to keep a closer eye on your portfolio, in order to know when your variance bands are triggered. But this extra work has a payoff: it ensures that your portfolio will never stray beyond the variance that you are comfortable with.
That said, choosing one method over the other will not lead to a meaningful performance difference long-term, so I would just advise using whichever one work best for you.
Tracking Your Portfolio
You have probably realized that in order to rebalance, you need to have a way of tracking your portfolio, and evaluating your current allocation against your target allocation. There are several ways to do this, but one of the easiest is to use a portfolio tracking spreadsheet. I’ve created a basic one for FFWF that you can use going forward, and up next in Part 15, we are going to walk through the steps for how to set it up and use it.
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