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Rebalancing Your Portfolio

You set an investment goal. You figure out how much risk you're comfortable with and if you think it's enough to meet that goal. You allocate your investments. Then what? Your investment values fluctuate as market conditions change, so you need to reallocate your investment mix in your portfolio from time to time to make sure that it's lined up just the way you want.

Especially if you invest the same amount into each asset class on a recurring basis, it might be surprising to peek at your portfolio and learn that your allocation percentages are way off. That's because no asset class performs the same way all the time. When one class has a higher return, it's likely to represent a larger portion of your account value. If another class is underperforming, it's probably making up a smaller portion than you may expect.

It Could Happen to You

As an example of how an asset allocation can drift, consider a portfolio with 60% allocated to equities, 30% allocated to fixed income investments, and 10% to cash.

In this hypothetical example, suppose the return on your equity investments was much higher than the average return for that asset class. Rather than the long-term average of about 10% before inflation and taxes, say it was closer to 25%. At the same time, suppose the return on long-term fixed income investments averaged about 3.5%. (That's less than the average for this asset class, which is closer to 5.5%). Finally, suppose cash investments returned a lower than average 1%.

What would that mean for an allocation than began as a 60-30-10 relationship? It would be closer to 64-27-9. That shift isn't particularly dramatic, but another year of similar returns could increase the equity allocation to 67% or 68% while reducing debt to 24% to 25% and cash to less than 8%.

If your portfolio allocation shifts, but your risk tolerance and financial goals haven't changed, you may want to think about rebalancing your portfolio to bring it back to where you want it to be. Consider making it part of your annual assessment of the progress you're making toward your financial goals.

Keeping Your Balance

To return to your original asset allocation, you really have two ways to do this:

  1. You can sell some of the asset class that's increased the most in value and reinvest the proceeds into the lagging class (or classes).
  2. You can direct your new investments into the lagging asset class (or classes) until your allocation mix looks a lot closer to your original.

Why on earth would someone want to rebalance their portfolio? If equities are doing so well and fixed income so poorly, does it really make sense to get out of the winners and buy the losers? One reason is to prevent your portfolio from becoming more risky than you're comfortable with, or too conservative to meet your goals.

Rebalancing takes discipline. You set up your asset allocation the way that you did for a reason - because that matched your goals and your risk tolerance. Allocation drift is natural, and common. While you may hesitate to sell an investment that is performing really well, remember that you don't have to sell your entire holding. And if you sell an investment that has increased in value, you're following a classic piece of investment advice, which is to "sell high." Of course, your goals and your risk tolerance may change - do what's best for you.

There's one more thing to keep in mind. Investments in an asset class that's underperforming tend to be selling for less than they would be if it were over-performing. That allows you to "buy low."

Tax Implications

If selling some of your investments is part of your rebalancing strategy (in a taxable account, not an IRA), don't forget about the potential tax consequences. Whenever you sell at a gain, you owe taxes on the amount of that gain. There are ways to handle the transaction that could reduce what you owe, but you have to plan ahead. Talk to a tax professional!