Finding Your Balance
When you first set up an investment, you (and your financial advisor) carefully created allocation ratios to fit your needs and chose an asset mix to match. Over time, however, those allocations may have strayed from their original benchmarks, leaving the portfolio too heavy in one asset class and underweight in others.
This imbalance can occur due to a variety of reasons. Perhaps the weight of an asset class within your portfolio shifted as assets rose and fell in value due to performance. Or maybe you sold or bought assets based on news headlines or events, skewing the portfolio away from its original allocations. In some cases, imbalance is caused after reinvesting back into high-performing assets and putting too much weight in one asset class. Finally, a portfolio may become imbalanced as the result of selling off assets for the purpose of harvesting losses.
If a portfolio has shifted away from its initial asset benchmarks, it may be time to analyze whether a rebalance is required.
There are three common approaches to rebalancing: redirecting money to lagging asset classes, adding new investments to lagging asset classes or selling off a portion of holdings within outperforming asset classes (or some combination of the three).
Some Benefits of Rebalancing
No matter which method is used, rebalancing can bring a host of potential benefits, including:
- Rebalancing can renew discipline. Investing is a marathon — not a sprint. And like marathon training, investing is a practice with a long-term outlook, requiring discipline, strategy and focus. Many individuals lose sight of their discipline as their investing practice grows mundane or feels tedious. Rebalancing reminds you of the original boundaries you set for your portfolio and why you established them in the first place.
- Rebalancing can remove unnecessary risk. This is especially true when we experience a long-running bull market, during which time investors may become too heavily weighted in stocks, creating a portfolio that exceeds their risk tolerance. Rebalancing can help identify potential areas of risk before they become a problem.
- Rebalancing can create additional return potential. On the flip side of reducing unnecessary risk, rebalancing may also help investors identify opportunities to improve returns within the portfolio. This is especially true as markets shift and different asset classes become over-performers.
What to Consider During a Rebalance
Before shifting assets around to realign with initial allocation benchmarks, however, it may be important to consider how rebalancing might impact your portfolio. Here are four things to think about before rebalancing:
- There are costs associated with rebalancing. Account shifting could result in potential sales charges and other fees. Can your portfolio absorb these costs at this time? If not, rebalancing may need to wait.
- Rebalancing may produce capital gains in a taxable account. An investor may see an increase in their tax bill if capital gains result from selling off assets as part of a rebalance. However, this could potentially be offset by harvesting losses from underperforming assets in the portfolio.
- Should the allocation benchmarks be changed? Portfolio allocations should change as people do. Many investors don’t consider that their risk tolerance decreases as their age increases — and sometimes never act to reduce risk as they near retirement. Your asset allocation should be forward-looking; what worked for you in the past may no longer work for you, due to changes in your life, markets or economic environment. In some cases, you may need to change your asset allocation boundaries altogether.
- Rebalancing shouldn’t just happen by the calendar. Many investors and their advisors review portfolios for potential rebalancing around the first of the year, especially after assets have been sold to harvest losses for tax purposes. However, you shouldn’t rebalance just because the calendar says it’s time to do so. Instead, rebalancing should occur any time allocations have strayed a predetermined amount from their original limit. One example: You could set a personal rule to consider rebalancing any time allocations have strayed more than 5% outside the original lines.
By proactively aligning your asset allocation with current circumstances, you can increase the likelihood of reaching your financial goals. If you haven’t done so recently, we recommend talking with your financial advisor to make sure your portfolio is balanced and well-positioned to take advantage of opportunities in the second half of 2023.
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