Portfolio rebalancing is important in long-term financial management. You may have a carefully considered allocation. But it will tend to change over time even without any deliberate action on your part. So why, and when, should you adjust your investments?

Read on to learn more!

A quick explanation of what it means to rebalance

It involves looking at the combination of assets in a portfolio and then making adjustments so as to bring it back in line with the desired or recommended asset classes.

A portfolio could have been allocated a particular percentage of its total amount to equities and at the same time included a fixed-income allocation. In the event that equity markets have performed well over a long period, that percentage might end up being much higher than the figure it was originally intended to be.

In this situation, rebalancing generally means selling some of the assets which are overrepresented and purchasing additional amounts of those which are underrepresented. This action serves to even out the allocation among the asset classes.

Why it matters

As time goes on, the portfolio could change quite a bit from the way it was originally allocated. It might cease to reflect the level of risk that the investor originally considered to be appropriate.

The equity allocation that an investor chooses to make is based on a specific:

• Time horizon
• Income stream
• Asset position
• Personal comfort with volatility.

If the changes in the market have caused the investor’s portfolio to have too great a proportion of equities, then the portfolio is now assuming more risk than the investor wanted.

In the event of substantial market declines, a portfolio that has drifted might produce losses which are greater than the ones the investor had expected according to the initial portfolio structure.

When to consider rebalancing

There are two general approaches to deciding when to rebalance activity:

Calendar based

The portfolio is examined each quarter, every six months, or annually, and adjustments are made whenever it differs from the desired allocation percentage by a large amount.

Threshold based

This involves continuously monitoring the portfolio and then adjusting it accordingly whenever it moves away from the specified percentage of the target asset class; these adjustments take place no matter when the previous rebalancing was carried out.

Many of the Investment Management Firms Madison WI include features of both, such as scheduled reviews and continuously keeping an eye out for major market events which might necessitate a review outside of the normal review schedule.

How market conditions apply to this situation

In fact, when rebalancing is carried out, it means selling the assets that have performed well over the previous period and then using the money obtained from the sale to buy assets that have not performed as well during that same period.

This is the opposite of what many investors do in a strong market: they usually buy and hold the investments they like and sell those they don’t. Rebalancing is a systematic approach that counters this instinct by taking into account what is currently in the portfolio rather than current market sentiment.

It is in such cases that involving knowledgeable professionals helps. They are able to offer an objective view of the portfolio’s structure, especially when markets are volatile or showing strong trends.

Tax considerations in rebalancing

It is possible that rebalancing in a taxable account will result in capital gains which will then be taxable upon sale. This does not imply that rebalancing should not take place in a taxable account, but it does mean that the strategy has to take into account the tax consequences of each rebalancing action.

Adding money to underweighted asset classes can reduce the need to sell. Taking money out of overweighted asset classes can reduce the need to buy.

You should carefully consider these tax implications. A financial professional can help you evaluate how taxes may impact your plan.

Evaluating the benefits and drawbacks of portfolio rebalancing

Benefits

• Rebalancing helps maintain investors’ portfolios in line with their desired rate of return and risk tolerance.
• It keeps the asset allocation consistent with the investment strategy.
• It’s a methodical technique that helps reduce exposure to risk.
• It can be adjusted based on evolving financial requirements and investing objectives.
• It can be done by portfolio managers or seasoned individual investors.

Drawbacks

• Transaction expenses associated with rebalancing may lower net income.
• Investors may miss future price increases if valuable equities are sold for rebalancing.
• Unnecessary rebalancing can significantly increase costs for the investor.
• You need investment knowledge and experience to rebalance a portfolio well and reduce the exposure to risk as needed.

You may consider engaging a Certified Financial Planner Madison WI for help in readjusting your portfolio.

The bottom line

Conducting periodic adjustments to your portfolio can help maximize long-term performance and keep it in line with your financial objectives.