Imagine this – You spent a bunch of time finding the perfect allocation for your investment portfolio (perfect doesn’t exist, but just entertain it for a sec). You come back a few months later to find your allocations are all off. All the different assets you’re invested in have fluctuated at different rates, meaning that you’re more heavily invested in one area than you’d like. So what do you do? Well, you may need to rebalance your portfolio.
What Does It Mean to Rebalance Your Portfolio?
When you set up an investing portfolio, you will typically define percentages to allocate across categories. This could be across sectors (e.g. tech, banks, etc.), across category (e.g. growth, blue-chip, etc.), across index funds, or across asset classes (e.g. stocks, bonds, crypto, etc.). For the sake of an example let’s imagine that you initially defined that you wanted to hold 75% stocks, and 25% bonds, and you purchase securities accordingly.
Some time passes and all of a sudden you find that your stocks have done really well and now make up 85% of your portfolio, and bonds 15%. Rebalancing would mean that you sell stocks, and buy bonds to bring yourself back to your specified allocation.
Why Should You Rebalance?
Now you may be asking, my stocks are doing well, why should I sell them and put it into bonds where I’m getting reduced returns? To answer this, I’d go back to your reasoning for your initial allocation. You likely chose your allocation based on your specific risk appetite, and your desire for diversification.
When you stray from your defined allocation, you have outsized exposure to certain parts of the market. Let’s think about this with the above example again. Your desired allocation is 75% stocks, and 25% bonds. This gives you high potential returns through your stocks, and some security with the bonds. Let’s explore the reasoning for rebalancing in either direction:
- Market went up – Stocks now make up 85% and bonds make up 15%. You now have increases risk as you’re holding more stocks. By rebalancing you are restoring your risk exposure, and locking in some of your gains by converting them into bonds.
- Market went down – Stocks now make up 65% and bonds make up 35%. You are no longer in a good position to capitalize on the eventual market rebounds. By rebalancing, you will have a greater upside on the rebound, and you can purchase stocks at a lower price.
As you can see, rebalancing can make sense regardless of how your allocation changes. Now keep in mind you’re always at the freedom to change your allocation – so don’t feel locked into your initial allocation percentages.
When Should You Rebalance Your Portfolio?
Now for the most important question – when or how often should you rebalance your portfolio? There are two triggers to rebalance your portfolio: Time, or amount of drift.
One possible trigger to prompt you to rebalance is time. You should be rebalancing your portfolio at least once a year. A year is an adequate amount of time for things to shift and for the stock market to make some moves. On the other end, I wouldn’t rebalance any more often then every 3-6 months. If you rebalance too often, it defeates the purpose of passive investment, and you could start to rack up transaction fees – which would eat into your returns.
The other trigger is the amount of drift. There’s an interesting concept I found called the 5/25 rule for rebalancing your portfolio. It states that you should only rebalance if an asset or category has drifted from it’s original target by an absolute 5%, or a relative of 25% – whichever is less. So with the above example of 75% stocks and 25% bonds, you would rebalance any time either of them changes by 5%. If you had a smaller allocation of 10%, you would rebalance at 25% relative – or 2.5%. I’ve never used this concept, but it’s an interesting one to ponder and could work quite well.
If it’s been a year since you rebalanced, and you find your allocations are right (within a couple percent), then just leave your money to grow!
How to Rebalance Your Portfolio
Returning your portfolio to your desired allocation is pretty easy. First, you need to record the total value of your account. Start with the category that is above it’s desired allocation, then for each category:
- Subtract the actual percentage of that category from your desired allocation.
- Multiply this difference percentage times the total account value
If this value is positive, that means that you need to sell that value of the category. If it’s negative, then you need to buy that amount.
For example, imagine in a $10,000 account I wanted to be at 75% stocks and 25% bonds, but I’m actually at 85% stocks and 15% bonds:
- 85% – 75% = 10%
- $10,000 * 10% = $1,000
This means that I need to sell $1,000 worth of stocks (and buy $1,000) worth of bonds.
Quick Tip – Use Your Dividends to Reallocate
One trick I like to use to keep my account at the correct allocation is to use the dividends. Depending on the types of assets you’ve got in your account, you may get dividends on a regular basis. For example, my stock index funds return a dividend on a quarterly basis, and the bonds return monthly. Once the cash in your account builds up enough (or quarterly, whichever is sooner), you can use it to purchase more assets that need to have a higher allocation.
So if I find that my bond allocation is low, I’ll use the dividends to purchase more bonds to keep the percentage about where I want. This also serves the purpose of keeping your money working for you, which is key for building wealth.
Conclusion
Rebalancing your portfolio is key to keep your risk exposure and growth potential at a level you’re comfortable with. You should be rebalancing as often as quarterly, or as seldom as annually, but it’s worth it to keep an eye on the allocations. You can also use dividends to adjust your allocations on the fly.
To learn more about my recommended investing style, see Index Fund Investing.
Looking to get started but having a hard time? Check out my article on taking action: The 85% Solution