When Should You Rebalance Your Portfolio?

 
© (Getty Images) Even if a family member's poor money skills won't affect your pocketbook, sometimes a money conversation is necessary.
Rebalancing is an important (and often overlooked) step in creating and maintaining a diversified investment portfolio that is also consistent with your risk tolerance.
After you set up your initial asset allocation, the different investments in your portfolio will gain or lose value as the market goes up and down. Since your underlying holdings are not the same, they will all behave differently as the market moves, some growing much faster than others.
In order to realign your current portfolio to your target asset allocation, you must rebalance.
Rebalance to align with your target asset allocation. When you first set up your asset allocation, you (ideally) did so with your risk tolerance, investment goals, and other considerations like time horizon in mind. In evaluating these factors together, you may be able to determine how conservatively you can be invested and still reach your goals.
[See: 8 Times When You Should Sell a Stock.]
Your individual risk tolerance is a key component here. Taking on more risk than you're comfortable with to achieve a goal more quickly can have disastrous consequences on a portfolio. Truly risk-averse investors often panic and sell when the market sustains continued losses, only to re-enter when prices are high.
Whether you are working within the confines of your retirement plan or have a vast universe of investment options available in a rollover individual retirement account or brokerage account, creating an asset allocation that is appropriate for your varied goals can be complicated. Whatever you're investing for, if you aren't confident in your ability to develop and maintain a risk-adjusted diversified portfolio, consider working with a fee-only financial advisor and fiduciary.
When should you rebalance your portfolio? Rebalancing is the process of realigning your current portfolio holdings to your target asset allocation. What this truly entails is counterintuitive to many investors. When you rebalance, you sell positions that outperformed and use the proceeds to buy more of a position that did not grow as quickly.
Although this may be a bit painful for some, recall two important principles of investing: past performance does not indicate future results; and that holding a diversified portfolio can help mitigate losses during the market's inevitable ups and downs.
Here's an example. Suppose your target asset allocation contains the following: 50 percent large-cap U.S. equity, 20 percent small-cap U.S. equity, 15 percent foreign developed markets equity, and 15 percent U.S. fixed income.
Now suppose the following year your holdings are 55 percent large-cap U.S. equity, 30 percent small-cap U.S. equity, 7 percent foreign developed markets equity, and 8 percent U.S. fixed income.
As a result of the market, your portfolio is now weighted 8 percent more heavily toward equity than originally modeled. Further, the allocation to small-cap equity had increased 50 percent from the initial asset allocation.
Asset classes with more reward potential also carry greater risk. As these holdings benefit from a favorable market cycle, rebalancing involves liquidating out a portion of your holdings and redistributing the proceeds to other assets in your portfolio. This process can not only help protect your investments by limiting your exposure during a market downturn, but it can also help ensure you maintain adequate exposure to potential gains in other asset classes.
It is possible to rebalance your portfolio at any time, although it is typically only recommended once or twice per year. As you review your holdings, try to set bands in which you're comfortable with an asset class straying from its target allocation. In another words, your holdings will continue to shift with the market, so it may not be worth rebalancing to correct a small 2 percent variation.
Tax consequences of rebalancing a brokerage account. When you rebalance a tax-deferred retirement account like a traditional IRA, 401(k), or 403(b), there are no immediate tax consequences. However, when you rebalance a taxable brokerage account, you will owe capital gains tax on your gains, even if you reinvest the proceeds. Selling other positions at a loss can help by offsetting your gains, but there may still be tax implications to the extent your overall gains exceed your losses. As such, if you're planning on overhauling your investment strategy, you may want to do so over two years.
There can be other costs to rebalancing as well, such as trade fees and commissions. Working with a fee-only advisor can help offset the expense of rebalancing, as they do not receive commissions or sell products like insurance or securities.
An advisor can also help you develop your investment strategy and create a financial model to integrate all of your goals together in one cohesive plan. Self-managing investors often turn to financial products, like annuities or permanent life insurance, to help put cash to work when they're unsure of how to create an asset allocation. Unfortunately, these types of products often carry very high fees for the investor and sizable commissions for the individual selling the product.

Source