Rebalancing Your Portfolio

When you allocate the assets in your portfolio, you choose the percentage of the total account value to assign to each asset class, including stocks and stock funds, bonds and bond funds, and cash equivalents. Your choices depend on a number of factors, including your age, the goals you’re investing to achieve, your time frame for reaching them and the level of risk you’re willing to take.

Choosing an allocation isn’t the end of the story, though. As investment markets move up and down, different asset classes increase and decrease in value at different rates. Over time, the ones that grow more quickly will make up a greater percentage of your portfolio than you originally planned. For instance, an asset class that initially made up 25% of your portfolio might, at some point, increase to 40% while another asset class may shrink from 25% to 10%.

Provided your goals and your risk tolerance haven't changed, you may want to rebalance your holdings to restore your original allocation. Without this rebalancing, you may find you have a portfolio that has more risk or a smaller long-term return potential than you're seeking. That could interfere with your plans for meeting your financial goals.

Ways to rebalance

You can rebalance your portfolio in different ways.

 1. One way to rebalance is to sell off a portion of the asset class that has increased most in value and reinvest those profits in the lagging asset class.

2. Or, you can change the way your future contributions are allocated, putting more money into the lagging asset class until things are back into the balance you seek.

3. You can also add new investments to your portfolio in the lagging asset class and funnel your contributions to those investments.

While all three methods work, many investors are uncomfortable with the first approach since it seems illogical to sell investments that are doing well to buy those that are not. Remember, though, that no asset class is the strongest performer year in and year out. It may be smarter to sell at a high price than to watch the value of an investment drop.

When to rebalance

Rebalancing your portfolio isn't something you need to worry about every day. Many financial advisers suggest that reviewing and reallocating once a year is adequate. Others suggest that you can ignore imbalances unless the value of any class exceeds the allocation you originally selected by 15% or more.

There's no official timetable for rebalancing, and the further away your retirement is, the less important frequent rebalancing is likely to be.

Sometimes your mutual fund or retirement plan provider will offer a reallocation service, especially if you invest in a lifecycle fund. Those funds may be rebalanced as frequently as every quarter, which may actually be too often to allow short-term gains and losses to even out.

You'll also want to watch the transaction fees in any automatic plan. Programmed rebalancing generally means added sales charges.

Tax impact of rebalancing

Remember, if you're rebalancing a taxable investment portfolio — by selling investments that have increased in value — to buy investments that have grown more slowly, you'll owe capital gains tax on the profits you realize. That means if you rebalance your portfolio in this way too frequently, you could end up owing the government significant amounts of tax.

A more tax-friendly approach may be to reallocate your periodic additions to the account into slower growing investments or to make additional investments in that category.

In addition to the possible tax impact of rebalancing, you should consider potential transaction fees unless they are included in a fee-based adviser account. Your financial adviser can help you identify rebalancing strategies that minimize trading costs.

Other changes to consider

As you get closer to retirement, you may want to shift some of your assets out of potentially volatile growth investments, such as stocks and stock funds, into income-producing investments with more stable values. This realignment is described as reallocation. You may also want to reallocate in response to major life events that have an impact on your financial situation, such as getting married or divorced, having children, or changing jobs.

You can use the same methods for reallocating as you do for rebalancing, bearing in mind the same potential fee and tax consequences.

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Print copies of the 2016 Texas Investor Guide are available on request. Contact Robert Elder, Communications & Investor Education Coordinator, at relder@ssb.texas.gov.