A Guide to Rebalancing Your Investment Portfolio
As is often said, “don’t put all your eggs in one basket” or, “no investment should zig while another zags”. Rebalancing your portfolio can help ensure that its actual and desired asset allocation don’t drift too far out of line with each other.
Rebalancing can become complex when multiple accounts and taxes come into play.
Asset Allocation
Asset allocation refers to the process of allocating your investments across various asset classes such as equity or debt based on various criteria, including your financial goals and risk tolerance. As markets fluctuate, your investments’ performance could cause their allocation percentages to stray from what was originally set, so periodic rebalancing should take place.
Rebalancing is a strategy to manage risk by selling off overperforming assets to purchase underperforming ones. For instance, if your bonds have performed exceptionally well recently and you’re overweight in them, selling some might help bring their percentage closer to where it should be.
Rebalancing can assist with tax planning by shifting some of your cash flows toward underweighted asset classes in taxable accounts. Rebalancing does not guarantee superior performance or eliminate risk; consult your financial professional and tax adviser about designing an individual rebalancing strategy that’s tailored for you.
Time to Rebalance
When you initially created your investment portfolio, several considerations likely came into play. Most likely you selected an asset mix comprising stocks and bonds that fits with both your financial goals and risk tolerance.
Market fluctuations can cause your asset allocation to shift over time, creating what’s known as portfolio drift and potentially jeopardizing your investment goals.
Assuming your risk profile dictated that 70% of your portfolio was invested in stocks initially, but due to market fluctuations your allocation has now changed to 82% stocks and 18% bonds it may be time for a rebalance.
How often you rebalance your investment portfolio will depend on several factors such as transaction costs, tax considerations and whether or not you invest in individual accounts or target date funds. It is recommended to rebalance at least annually or more frequently if your goal is to align investments with current financial needs and risk tolerance; creating a disciplined process for rebalancing can minimize unnecessary fees while helping you meet financial goals more easily.
Tax Implications
Rebalancing can cause capital gains in taxable accounts. Rebalancing on a regular schedule may help minimize these events, while large market moves or other factors could require off-schedule rebalancing. Investors should understand the tax implications associated with each account type before selecting an approach that’s both consistent and tax efficient.
Rebalancing by taking advantage of cash flow can also enhance its tax efficiency. When an asset class becomes overweighted, rather than selling investments to balance things out, investors could use their cash to buy underweighted investments with reduced transaction costs and capital gains taxes.
Holding tax-efficient investments like stock index funds in taxable accounts, while less tax-efficient bonds such as those held in tax-advantaged accounts is another effective strategy to optimize the tax efficiency of rebalancing investments. Investors should work with their financial advisor to create a comprehensive plan that takes into account all variables involved with rebalancing their portfolio – this plan can help them remain disciplined during periods of market instability while still meeting long-term investment goals.
Fees
As part of your regular portfolio review process, it’s crucial that you understand all components of your investment strategy and their interaction. Furthermore, consider your goals, time horizon and level of comfort with potential fluctuations in investments’ values. Also avoid overtrading or having an unrealistic sense of urgency by checking too frequently.
Over time, your portfolio’s asset allocation model may become out-of-whack as certain investments increase in size while others decrease in number. Rebalancing helps restore original proportions by selling certain investments and buying others – these transactions incur sales fees as well as potential capital gains taxes in non-registered accounts unless using tax-advantaged accounts such as RRSPs or IRAs with low transaction costs; alternatively you could direct new funds directly into underweighted asset classes in non-taxable accounts in order to reduce rebalancing costs without incurring tax bills incurred when selling.
