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What You Should Know About Rebalancing

One of the comments I received on Wednesday's post about reacting to returns and volatility asked about my thoughts on rebalancing. You can read my response in the comments section, but here's some additional thoughts on rebalancing your portfolio.

Rebalancing is a key part of a winning investment strategy. Each asset class within a portfolio will change in value by a different percentage over time, altering the risk (and expected return) of the portfolio.

There are many different types of rebalancing strategies. In general, I prefer setting tolerance ranges for each asset class. When an asset class gets out of its tolerance range, you should either rebalance to the target allocation or to within the tolerance range. For more information on this, see my book The Only Guide to a Winning Investment Strategy You'll Ever Need.

Rebalancing restores a portfolio to its original allocation and intended risk exposure, but it comes with a cost. When rebalancing, you may have to pay transaction fees or taxes (from realization of capital gains). Here are some tips for rebalancing your portfolio:

  • Whenever possible, use new cash to rebalance the portfolio. This helps limit the number of trades used in rebalancing and avoid realizing capital gains.
  • Don't rebalance in a taxable account if it results in realizing short-term capital gains unless there are losses to offset the gains. You're better off waiting until the losses become long term to rebalance.
  • When rebalancing requires realizing capital gains, rebalance only to the tolerance range you've set, rather than the target allocation.
  • Before realizing capital gains, check to see if you'll have investable funds available soon.
  • Rebalance in tax-deferred accounts first if your taxable positions are at a gain. If your taxable accounts are at a loss, rebalancing should be done in taxable accounts first.
Without rebalancing the portfolio, your portfolio will become more aggressive or more conservative than you originally intended. Keep in mind that it's a test of discipline. You must be able to sell equities when stocks are rising, and buy when they're falling.

David Swensen, chief investment officer of the Yale Endowment and author of Unconventional Success, noted, "Dramatic bear markets signal the need for significant purchases of losers, while extraordinary bull markets call for substantial sales of winners. When markets make radical moves, investors demonstrate either the courage or the cowardice of their convictions."