How Do You Rebalance an Investment Portfolio?

How Do You Rebalance an Investment Portfolio?

To make an investment account most effective, you can't just open it, plop in your money and forget about it.

Yes, you do want to invest for the long haul, so your money has more time to potentially grow, but, periodically, you should adjust your portfolio.

What does that mean? In short, you want to make sure your portfolio has a mix of assets which reflects the amount of financial risk you currently want to take on (more on how to figure that out in a minute).

This task is called rebalancing.

How Rebalancing Works

Rebalancing starts with an asset allocation—that’s the percentage of assets (for the average person, this is stocks and bonds) that make up your account. The ideal mix varies based on your age, time frame and risk tolerance.

When you rebalance, you're essentially selling some of the investments that have performed better than other holdings for the year, and buying some that have been underperforming to get your asset allocation back where you assigned it.
For instance, if you’re rebalancing a retirement account that you'll need to access in 20 years, you may choose a riskier mix of stocks and bonds, since you may have time to make the money back should the market take a dive. If your goal has a shorter time horizon, such as a down payment on your dream home in eight years, you may likely invest this money very differently. In this case, you may want to take on less risk, since you wouldn't have enough time to earn the money back should the market go south.

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Let’s say you’ve determined that you want to have a moderate asset allocation consisting of 60% stocks and 40% bonds. This allocation is written "60/40." After a year, you might have 66% stocks and 34% bonds, because your stocks have been more profitable than your bonds in this example. Your portfolio is now 66/34.

To rebalance, you would sell 6% of your stocks and buy 6% in bonds to bring your allocation back to 60/40. This is the basic concept behind rebalancing.

Generally, you should rebalance at least once a year. To get an idea of an appropriate mix for your own investment portfolio, a good place to start is by filling out a free risk tolerance questionnaire.

There are some exceptions, of course: If an investment holding has changed by less than 5% (meaning your 60/40 became something more like 62/38), you might want to wait before you rebalance. That's because there are often fees to buy or sell funds that you won't want to pay for such a small adjustment. More on that, below.

If You're Just Starting Out

If you’re unfamiliar with investing, stick to low-cost index funds and ETFs, instead of choosing managed mutual funds (which have higher fees) or individual stocks. Call and find out if your brokerage firm has a free tool to help you choose the right asset allocation for your situation. A few of the tools offered by firms include:

Sometimes your 401(k) provider will actually offer an automatic rebalancing tool. In fact, every company does this a little differently, so ask which services your brokerage offers: Some companies will ask you to fill out additional paperwork, some will walk you through the process online and some will require your go-ahead before rebalancing. No matter how your brokerage works, look at your quarterly statements to make sure everything is accurate.

Another option, if you’re just starting out and don't want to take care of rebalancing yourself, is to choose a target-date retirement fund. These funds are a mix of stocks and bonds that automatically get more conservative over time. In this case, the rebalancing is left to the mutual fund manager, and you don’t have to make changes unless your financial situation changes.

If your account—like an IRA or 401(k)—offers target date funds from different fund families (such as Fidelity, Vanguard or T. Rowe Price), then you may want to compare them on morningstar.com by entering their ticker symbols, which is a series of five letters you can find after the fund name.

On Morningstar, you're looking for a low expense ratio--the fee that the fund charges for administration, management and advertising, which should ideally be under .8% and never over 1.2%--as well as the specific stocks and bonds in that fund. You can also look into the track record of the fund manager, but remember that in the investing world, past performance isn't necessarily indicative of future results.

What If I Have Extensive Investments?

If you have an investment portfolio over $1 million, you may want to rebalance more frequently than the usual once a year--probably quarterly or every six months. If your portfolio is this large, we highly recommend working with a CFP® who is also an investment advisor. This person can help monitor and rebalance these accounts for you, since, with such a large portfolio, there are more complex tax planning and retirement planning issues to consider.

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While I'm looking at rebalancing in terms of plain old stocks and bonds for the sake of simplicity, each of these categories is actually each divided into many different asset classes and asset categories. Technically, your portfolio might consist of U.S. stocks, foreign stocks, U.S. bonds, foreign bonds, commodities, cash, REITs, and more.

U.S. stocks are often divided by market capitalization: large cap, mid-cap, small-cap ... and then again by growth versus value stocks. Bonds are often divided between other categories, such as government bonds, inflation-protected bonds (TIPS) and corporate bonds ... as well as high yield bonds, multi-sector bonds, and municipal bonds. We haven’t even touched on alternative investments that include REITs, commodities, precious metals and much more!

If you have an extensive portfolio and need more help with the different types of stocks and bonds, I recommend consulting a professional familiar with your situation.

As mentioned above, working with a CFP® who is also an investment advisor is one option for investing help.

For more information on investing, asset allocation and rebalancing, sign up for LearnVest's free, 7-day Start Investing Bootcamp.

Sophia Bera, is a CFP® and the founder of Gen Y Planning, LLC, in Minneapolis, Minn.

Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial advisor for advice specific to your financial situation.

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