Investment portfolio rebalancing is key to long-term success

Jeff Witz, CFP

When you begin investing, a critical step is to select your investment allocation. This is not only when you decide what percentage of your investments to put into lower-risk investments like bonds and higher-risk investments like equities, but also when you select what percentage to put into specific asset classes such as domestic large companies, domestic small companies, international companies, domestic bonds, international bonds, real estate, and cash. Each of these categories can be broken down even further, like growth vs value equities or long-term vs short-term bonds. An ideal allocation minimizes as much risk as possible through diversification while still targeting a certain average rate of return.

However, over time, an allocation tends to stray from its target percentages. Certain asset classes may outperform others. If you allow an asset class to stray too far from its target percentage, you could end up with a completely different portfolio no longer suited to your long-term investment objectives.

Effective investing requires diligent portfolio maintenance, and rebalancing is the remedy for asset class “drift.” This means selling assets that have risen in value and buying more of the assets that have dropped in value. The purpose of rebalancing is to return a portfolio to its original target allocation. This restores the strategic structure in the portfolio and puts you back on track to pursue long-term goals.

At first glance, rebalancing may seem counterproductive—why sell a portion of outperforming asset classes and acquire a larger share of underperforming ones? Although intuition might suggest that selling previous winners can hinder returns in the future, that logic is flawed. Past performance may not continue in the future, as historical data show that asset classes tend to rotate top performers year-over-year. There’s no reliable way to predict future returns, but being well diversified across asset classes increases the likelihood that you’re invested in that year’s best performer.

Equally important is choosing the original asset allocation based on your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions.

Before selling and buying investments for the purpose of rebalancing, tax implications should be considered. For example, in a taxable account, you may not want to sell a position that has a gain because you may need to pay capital gains taxes. In taxable accounts, often the best way to fund underweight positions is to contribute new money to the account or look for tax loss harvesting opportunities. The same concern does not exist for tax-advantaged accounts such as individual retirement accounts, 401(k)s, and 403(b)s. In these accounts, you can buy and sell as frequently as you want without having to incur capital gains taxes, so rebalancing can be done at any time.

Guidelines should be set for when to rebalance. Constantly buying and selling for the purpose of rebalancing can result in increased costs. Many investors choose a specific time to rebalance, such as every 3 months or once a year. Other investors choose to rebalance based on the percentage variance. For example, if the asset class strays 5% up or down from its target, that can be a signal it is time to rebalance.

Portfolio rebalancing is a necessary part of an effective investment strategy, and a routine check of your investments should be completed regularly to ensure they have not drifted too far from their intended percentage targets. Staying true to your risk and return preferences is a key to long-term investment success.

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