Asset allocation is about dividing your portfolio among various investment asset classes like stocks, bonds and cash, and sub-asset classes like small, large and midcap stocks. Bonds and international investments, as well as growth and value oriented equities are often part of a well-diversified portfolio.
In order to maintain your target asset allocation through the market’s ups and downs, it’s important to periodically review your portfolio for rebalancing. If the actual allocation of one or more asset classes varies from the target allocation by more than a specified amount then it is time to buy or sell holdings in this asset class to bring the allocation back to its target level.
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Your portfolio should be reviewed periodically to see if rebalancing is needed. This should be done at least annually, more often such as semiannually or quarterly if appropriate.
There are several reasons why portfolio rebalancing is important for investors.
Maintaining the proper level of portfolio risk
One of the main goals of asset allocation is to maintain a proper balance between the potential for downside risk versus the potential reward across your portfolio. Over time the performance of the various asset classes represented inside of your portfolio will vary both up and down depending on market and economic conditions. We have certainly seen this in the markets in 2022.
Over time these variations in performance will cause the actual allocation of your portfolio to vary from your target allocation. This can cause you to take too much or too little risk. After a significant gain in the market you may find yourself over allocated to stocks. This can expose your portfolio to a greater level of risk than desired should the markets head downward.
Imposing investment discipline
Having a regular rebalancing schedule enforces a level of discipline on you as an investor. With the stock market having experienced steep losses so far in 2022, rebalancing at regular intervals will likely lead to adding to your portfolio’s allocation to equity-based asset classes. This inherently forces you to “buy low.”
On the other side of the equation, during a period of extreme market gains, it can be tempting to ignore your rebalancing regimen and to simply let your “winners ride.” This is great if it works out, but this approach can expose you to added downside risk when the markets inevitably reverse themselves.
None of us are smarter than the markets. It’s not different this time. Reviewing your portfolio for rebalancing at regular, set intervals can help avoid the temptation to think you are smarter than the market. You aren’t.
A reason to review your portfolio
While it is not desirable for long-term investors to look at their investments daily, they should review their portfolios at regular defined intervals. This can go hand-in-hand with a regular rebalancing regimen.
In some cases you may be able to set some accounts to rebalance automatically at a set interval. This is common with 401(k) accounts. That is great, but you will still need to review these accounts to ensure that your investments are in line with your overall financial planning.
If you decide that semiannually is the appropriate interval to review your portfolio for rebalancing, then make this the time frame in which you review your portfolio performance and the investments held in the portfolio to see if any changes are needed.
Whether you stay with your existing portfolio allocations or decide to adjust them, be sure to rebalance your portfolio to bring the asset allocation back to your target allocation.
A key part of your financial plan
Over time as you review your progress toward your financial goals such as retirement, saving for college and others, you may find that you are ahead of schedule or perhaps you are lagging a bit behind where you had hoped to be.
Your investments play a key role in helping you to achieve your financial goals. You may determine that your target asset allocation needs to be adjusted to take on more or less risk based on a review of your progress against your financial plan. Once this decision has been made and any changes to your asset allocation have been made, it’s important to continue reviewing your asset allocation for possible rebalancing on a predetermined interval as you had done previously.
Combining rebalancing with other tasks
Rebalancing can be implemented in a number of ways beyond simply selling investments in asset classes whose allocation is higher than desired and buying investments in under allocated asset classes.
Allocate new money, including contributions to a 401(k) or similar employer-sponsored retirement plan, to asset classes whose allocation is too low. This can help avoid triggering taxable gains in taxable accounts.
Tax-loss harvesting in taxable accounts, if appropriate for your situation. The proceeds can be used to offset any capital gains realized this year, a portion can be used to offset other income if needed and any unused losses can be carried forward.
Consider using shares of appreciated securities as charitable contributions to organizations that accept this type of donation. This can help reduce your allocation to an asset class that is over allocated. The market value of the donated securities can be used as a charitable deduction if you itemize on your taxes. Additionally, you will not incur any capital-gains taxes as you would if the securities were sold for a realized gain.
Some studies have indicated that asset allocation is a larger factor in portfolio returns than security selection. For this and other reasons, rebalancing your portfolio if needed at regular intervals is a crucial part of the investing process.