Rebalancing Your Portfolio: Why, How and When

Despite chaotic headlines over the last year, the financial markets are mostly still riding high. What is going on? And, what are you supposed to do? A recent poll on NewRetirement found that most people with a retirement plan are simply sticking to their plan. They report that they have retirement under control — the power of a plan! The one thing they do on a regular basis? Rebalance. They rebalance investments when target allocations get out of whack.

So, what is rebalancing and why is it a wise financial move? Keep reading to find out.

Rebalancing is the process of selling some assets and buying others in order to realign your overall investment portfolio to your desired weightings — your desired asset allocation.

For example, let’s say you want to maintain 10% of your money in cash, 30% in bonds, and the remaining 60% in stocks or funds. But, due to recent losses in the stock market, the percent of your assets in stocks is now at 50%. In order to get back to your desired allocations, you would sell some bonds and use that money to buy more stocks to rebalance and return to your desired asset allocation.

It is traditionally advised that you rebalance at regular time intervals (once a quarter or once a year) or when your desired asset allocation is a pre specified percentage out of your target.

The goal of asset allocation is to give you the right level of risk and reward. You want a mix of investment types and diversification within each investment type.

• Investments in individual stocks, especially if all in the same business sector, can be risky and rewarding (higher potential rates of return, but also a good chance of losses if something goes wrong in that sector).
• A wide variety of individual stocks of different sizes in a variety of different sectors is less risky, but won’t offer you any guarantees.
• Diversified mutual and index funds give you less risk because you are naturally exposed to a wider variety of companies.
• Bonds and other fixed income investments have much less risk (and less reward, sometimes less than inflation).
• Cash has the least amount of risk in terms of losing the face value. However, cash loses value due to inflation and the rate of return on cash accounts is notoriously low — it rarely every keeps pace with inflation.

Your ideal asset allocation is highly personal and dependent on a wide variety of factors:

• Are you already retired?
• How old are you?
• How much of your needed income comes from your assets?
• Do you want to leave an inheritance?
• When will you need to tap assets and to what degree?
• Do you have any forms of fixed income such as Social Security or a pension?

There are lots of different ways allocate investments. Anything that allows you to achieve your optimal risk and reward balance and gives you access to the money you need, when you need it, is just fine. The trick is to pick a strategy and stick with it!

Investing, especially retirement investing, should not be an emotional endeavor. You want to have goals and a plan for achieving those goals.

Having a target asset allocation and a plan for maintaining that allocation is an important part of retirement planning success. You don’t want to make emotional decisions, panic, and buy high or sell low.

Your target asset allocation should probably include cash. An emergency fund is critical to maintain. Access to cash equal to at least six months of living expenses is a good rule of thumb for anyone.

However, if you are retired and living off of your assets, you probably want much more in liquid and low risk investments.

(Don’t have an emergency fund? Need money when the markets are down and you don’t want to sell investments? Evaluate these sources of emergency cash.)

Knowing if you need to rebalance means that you need to periodically — monthly, quarterly, or annually — take a peek at your account balances and assess your target allocation vs. where you are at that time period.

There are actually pros and cons to checking your investments frequently. Determine how often you want to check and stick to your schedule.

The standard rule of thumb is to rebalance when your target asset allocation is 5% or more off.

However, you should create your own strategy, commensurate with your goals and values. What is important is that you have a predetermined plan and goals for rebalancing.

Know your targets and set a plan for what you are going to do under certain conditions.

When markets get erratic and are in turmoil, you might be unsure about when exactly to rebalance, even if you are already on a set schedule.

Some experts suggest that you ride out the extreme volatility and rebalance when things flatten out.

In recent history, markets have recovered quickly — even from dramatic falls. The 2008–2009 financial crisis illustrates this vividly:

• Despite assurances from the pundits that investors should not expect a v-shaped recovery, stocks did exactly that.
• From the market low in March 2009, the Dow Jones index gained 30% in the span of just three months.
• By the end of the year it was up more than 60% from its low point. All of this occurred despite fear continuing to grip the market and the widespread belief that stocks were experiencing a false recovery and would fall below their March lows in short order.
• Investors who were still waiting for the “all clear” signal to get back into stocks instead saw stocks leave them in the dust.

When the stock market falls, the instinct is often to sell stocks. But, no. You want to do the opposite. If your assets are invested in stocks and bonds, when the stock market falls it is likely that you will have too big of a percentage of your assets in bonds and not enough in stocks.

It may seem counter intuitive, but by selling your bonds at a premium and buying stocks at a possible bargain, you could be enhancing your upside potential.

Remember, you want to sell high and buy low and that generally works with rebalancing to your target allocation.

You don’t have to rebalance your entire portfolio in one fell swoop, especially when you are uncertain what the markets will do next.

If, to get back to your target allocations, you need to sell $100,000 in bonds for example, start by selling and reinvesting just $25,000 and wait a week to see what happens in the markets.

You don’t need to do it all at once and with volatility, a 25% adjustment may end up being adequate.

When rebalancing, you can focus on selling specific investments that you don’t like and move into positions that you would be more comfortable holding for the long term like a low-cost index fund.

When the entire market goes down, one strategy that can pay off big is to improve the mix or the quality of your investments.

Remember, sell high!

If you have some stocks that are winners due to the pandemic (Netflix or Amazon, for example). You might want to consider selling the winners while they are soaring and buy index funds for the long haul.

NOTE: This — and everything else in this article — is not advice, just ideas to consider.

If you are working, always keep up with your regular savings contributions. No matter if the market is up or down.

If you have been considering a Roth conversion, doing the transfer when the market is down means that you’ll pay income taxes on a lower portfolio value.

And, when the market bounces back, you will benefit from future tax-free growth and withdrawals from the Roth account.

A few things to keep in mind:

• A Roth conversion is a permanent move. It used to be you could undo the conversion, but the Secure Act changed that.
• You’ll want to consider if a conversion will raise your Medicare Part B and Part D premiums in future years.
• Be sure you are careful to follow all conversion rules and reinvest according to your target allocations.
• Most importantly, make sure you have the money available to pay the taxes owed on the conversion. Ideally not from the account you are converting which reduces the efficiency of a conversion.

It is easy for you to model different Roth conversion amounts in the NewRetirement Planner. PlannerPlus users can:

• Model conversions at different amounts.
• Immediately see the difference in your lifetime tax burden.
• Analyze how it changes tax brackets and more.
• Get suggestions for how much to convert each year to maximize your savings and minimize taxes.

Learn more about Roth Conversions.

It is never a bad idea to call up your brokerage — or wherever you keep your money — and ask them for some free advice.

They can answer questions and help steer you in a good direction.

If you sell investments that aren’t tucked away in a tax-advantaged retirement account, you’ll have to pay capital gains taxes on the profits you made from those investments. However, if you sold any investments at a loss during the same year, you can wipe out those gains for tax purposes and avoid paying the related taxes.

This approach is known as tax loss harvesting.

Tax loss harvesting allows you to get rid of your loser investments while profiting a little from the transaction. In fact, if you have more losses than gains, you can use the extra losses to erase up to $3,000 of other taxable income (including the distributions from your traditional IRAs).

As you get older and your life evolves, your target allocations will need to evolve too.

Set a plan for when to evaluate and shift your overall asset allocation strategy.

Knowing your goals (your asset allocation targets) and what you are going to do if your goals are are not being met (rebalancing strategy) is a critical component of sane investing. It is not rocket science. It is actually pretty simple.

You can save yourself a lot of indecision and angst by writing it down and sticking to your plan.