4 Ways to Rebalance Your Portfolio

Don’t put all your eggs in one basket; never bet it all on one roll of the die. Whatever proverb you pick, it all boils down to the same thing: finding the right balance between risk and reward to minimize the chance of heartbreak, sleepless nights and financial distress.

Investors do that via asset allocation — building a balanced portfolio containing a diversified mix of assets. That way, when one investment unexpectedly zigs, the entire portfolio doesn’t zig along with it.

What it means to diversify

Investors need both ziggers and zaggers to smooth returns over the short and long term. Without both, a portfolio will not be able to withstand various market climates and may swing wildly to and fro even when the overall market seems calm and collected.

Diversification hedges against risk by investing money across various assets that don’t typically move together. You want a mix of things that are not affected by the same factors, in the same way, or at the same time. That isolates the damaging effects of any single type of investment and prevents it from dragging down your overall returns.

You can diversify your portfolio across:

• Asset classes: Stocks, bonds, cash.

• Company size: Large-capitalization, mid-cap or small-cap stocks.

• Geographic locations: Foreign companies or domestic ones that conduct a lot of business overseas.

• Industries: Consumer goods, energy, technology, health care.

• Investing styles: Mutual funds that invest in companies poised for rapid growth or ones that offer value; stocks that produce income (by paying out dividends).

The asset allocation model you’ve set will drift over time. Some investments will grow and become a bigger slice of your holdings while others will shrink. It’s natural for position sizes to morph over time. This is where rebalancing comes in.

Portfolio rebalancing strategies

Rebalancing simply means restoring a portfolio to its original makeup (asset allocation mix) by buying and selling investments. Simple concept, but sometimes complicated in practice.

An “investment portfolio” often means dealing with multiple financial accounts, including IRAs, 401(k)s, brokerage accounts, and even long-forgotten paper bonds. These accounts are subject to different taxes.

Tracking your investments makes reviewing your entire financial picture at once easier. But you don’t need to be an organizational guru to restore balance to your portfolio. Use one or any combination of these strategies to rebalance your portfolio:

1. The “While You’re at It” Strategy

Every time you invest new money (making monthly or quarterly IRA contributions, for example) or withdraw funds (if you’re already retired and drawing income from an account), tack on some rebalancing housekeeping.

Identify underrepresented or over-weighted asset types in your portfolio. Then you can beef up your position with each contribution check or lower your exposure with withdrawals. Depending on the size of your portfolio, you may not be able to accomplish all the rebalancing work that needs to be done. In that case, augment your homework with one of the other strategies.

2. The “Home Base” Strategy

Are most of your retirement assets in a single account, like a 401(k) or an IRA you rolled over when you left the company? Well, that’s convenient. Focus your rebalancing efforts on your main account, since what goes on in there has the biggest effect on the overall health of your savings. Even better if it’s one of the tax-advantaged retirement accounts above because selling within the account won’t generate any short- or long-term capital gains taxes.

Although you may have one “main” portfolio, don’t completely ignore the role assets play in smaller accounts, especially if the holdings in those portfolios are particularly concentrated. For example, if you’ve got a separate brokerage account where most investments are in growth stocks, your exposure to similar investments in your main account may need to be trimmed to balance your assets.

3. The “I Treat All My Children the Same” Strategy

Got multiple investment accounts with similar amounts in each? Treating each as a separate, fully balanced portfolio may be the way to go.

Decide on your target asset allocation mix and then deploy the same strategy in each. Depending on the investment selection in each account — e.g. your 401(k) fund options versus the wider assortment in a self-directed IRA — you won’t necessarily be able to invest in the exact same mutual fund in each account.

Look for a fund that offers similar exposure or has the same investment objective. Consider each account’s tax status and investment fees to minimize what you pay out of pocket or to the IRS.

4. The “Sweat the Biggest Stuff” Strategy

U.S. large-cap stocks are the biggest slice of the pie in most investors’ portfolios. (Remember, market cap, or capitalization, refers to the value of a company. Large market cap stocks belong to companies valued at or over 10 billion dollars).

Any shift — whether a giant sneeze or a momentary sniffle — can create a seismic shift in its original allocation. The good news is that it’s easy to identify the culprit throwing things out of balance. If you notice any major shift from your original allocation plan, check your large-cap stock positions first to see if the drift can be smoothed out by shifting money among those funds.

» Learn more about investment portfolios and how to build a good one

How often and when to rebalance your portfolio

Now that you know how to rebalance, the question is: when?

In April (tax time) or December (tax-loss harvesting time): Let the calendar be your guide. Many investors rebalance during other financial housekeeping tasks, such as preparing their taxes. Alternately, the end of the year is a good time to take advantage of tax-loss harvesting maneuvers to offset taxable gains that selling might trigger.

When an investment shifts more than 5%: Many investment pros recommend rebalancing when the performance of a single asset shifts more than 5%. The 5% rebalancing threshold is a good rule of thumb, but be careful about monkeying with your asset allocation mix too much (for instance, reacting to a short-term price movement). Doing so puts you at risk of locking in your loss when you sell and missing out on potential gains when the asset recovers.

Annually: A Vanguard study found that never rebalancing, or rebalancing less than every two years, increased portfolio drift away from the investor’s risk tolerance and preferences. Put differently, not rebalancing increased exposure to risk and volatility over time. As a result, the study recommended annual rebalancing for investors (though the rules for inventors who actively engage in tax-loss harvesting are different).

Remember, rebalancing is not about completely overhauling your portfolio. Major strategy shifts in your asset allocation plan should be infrequent and only in response to major life changes (getting closer to retirement) or shifts in investing goals (increasing liquidity for potential expenses or shifting into income-generating investments).

Rebalancing is meant to be restorative. Giving your portfolio enough breathing room to grow while keeping an eye on its overall health is the best rebalancing strategy of all.

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