How and when to rebalance your portfolio
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Updated: August 13, 2023
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Whether you're a new or seasoned investor, learning to rebalance your portfolio is an essential skill. Keep reading to get portfolio rebalancing strategies.
When you’re investing, one of the most important things to do is rebalance your portfolio. By doing this, you’re able better to assess your appetite for risk and your overall investment strategy. But what does rebalancing mean, and how do you do it? This article will walk you through everything you need to know to start rebalancing your portfolio the right way. Let’s get started.
What does it mean to rebalance your portfolio?
Rebalancing your investment portfolio means that you look at your target asset allocation at any given point in time and make adjustments to that allocation as necessary to align with your investment goals and objectives.
Let me give you an example. Say you wanted your investment portfolio to have 90% stocks and 10% bonds as a general allocation. Over time, those percentages will be skewed because the value of those shares and bonds will fluctuate. This will cause your asset allocation to be out of balance.
So if we saw a bullish year and your stocks’ value went up, you may end up with an allocation of something like 95% stocks and 5% bonds. While some may be okay with this, many people will want to rebalance, so things go back to the target portfolio allocation they’d initially designed.
Another example is individual shares of stock and asset classes. Cryptocurrency trading is hot right now, so say you only wanted 5% of your portfolio to be allocated to Bitcoin, and you had $100,000 to leverage. In this case, you’d start with $5,000 invested in Bitcoin (5%).
However, let’s say the value of that Bitcoin doubled after six months, and it’s now worth $10,000. Let’s also assume the value of your other assets didn’t change. Things are now out of balance because Bitcoin accounts for 10% of your portfolio ($10,000).
So, in this case, you may want to realign your investment portfolio to put the cryptocurrency goes back to 5% of the overall portfolio. There are a couple of ways you can do this, which I’ll get into more below.
Why is portfolio rebalancing important?
To build off the point above, rebalancing your portfolio is vital for a few reasons.
Maintain your target asset allocation
Probably the most critical reason to rebalance your investment portfolio is to maintain the asset allocation you want for your overall investment portfolio. Most investors have a general sense of what their asset allocation should be based on various factors, and when this gets out of whack, rebalancing that portfolio can help keep that strategy in line with your investment objectives.
Align with your risk tolerance
This goes along with the point above, and I’d consider it equally important. One of the biggest reasons investors set a target allocation is because of their overall appetite for risk. For instance, if you are in your 20s and have 30+ years of investing ahead of you, your risk appetite will probably be higher than someone in their late 50s who’s gearing down to retire.
Keeps you informed on your investments
By rebalancing your portfolio, you’re forced to evaluate your investments regularly. This is a good thing. For example, what might be an appropriate asset allocation in your 20s may no longer be the right allocation in your 30s. So by regularly evaluating your portfolio and rebalancing it, you’re able to take a look at your overall investment strategy and make adjustments as needed (rather than ignoring it altogether).
Things to consider before tackling your portfolio rebalancing
Below are the steps you should take when rebalancing your portfolio.
Figure out how much risk you’re willing to assume
The first step is to decide on what level of risk you’re ready to accept for your investment portfolio. The answer largely depends on your age and the time horizon you have to invest in the market, as well as your financial goals.
For example, if you’re in your early 20s, you may want to allocate a larger percentage of your investments to the stock market. By putting a heavier percentage in stocks vs. bonds, your level of risk will tend to be higher. Still, you have a greater chance of reaching the optimal desired returns for your portfolio since stocks (at least historically) have provided higher returns than most other types of investments.
Decide on your asset allocation
The next step is to have an understanding of: (1) what asset classes (i.e., shares of stock, bonds, mutual funds) you want in your portfolio; (2) what specific types of investments within those asset classes will make up the overall portfolio; and (3) what percentage those assets will account for in your overall investment mix.
Let’s keep it simple and say the two main asset classes you want in your investment mix are stocks and bonds. From there, you need to determine—at a high level—what percentage of your portfolio goes to shares of stock and what percentage goes to bonds. For the sake of argument, let’s say 90% goes into stocks, and 10% goes into bonds.
But, unless you’re investing in ETFs or index funds, you should take it a step further and determine what I would call a “sub-target-allocation” and select the specific types of stocks and bonds to invest in.
To be more precise, let’s start with the 90% you’ll invest in stocks. You could put all 90% in Apple stock, but that won’t make a lot of sense. You’ll be overly optimized toward one company and open yourself up to unnecessary risk.
To build in a buffer, you could instead allocate 20% to tech stocks, 20% to renewable energy stocks, and 50% to general high-growth stocks. This is just a rough example to give you a sense of the type of deep-dive you should do with your portfolio. You can go further by allocating specific percentages to specific investments.
Choose a rebalancing cadence
This can be monthly, quarterly, annually, or some other cadence that works best for you. If you’re a new investor, I recommend rebalancing on a quarterly or annual basis to start. This finds a good balance between keeping your portfolio optimized and rushing into terrible investment decisions (which can happen if you rebalance too frequently).
Once you choose a rebalancing cadence, stick to it. Meaning, that you don’t want to start the year off by saying you’ll rebalance once a quarter, do that for the first half of the year, then switch to monthly rebalancing afterward. It will throw off your portfolio. You can do this, but I don’t recommend it—especially for new investors.
Stick with a target allocation for a set amount of time
Ideally, you want to buy low and sell high, but this won’t always work out. So instead, when it’s time to rebalance, go into your investment account and determine which assets to sell and purchase. Alternatively, you may decide to buy a new asset that still fits within your overall asset allocation.
Say you started the year a 90% stocks and 10% bonds asset allocation, and you’ve decided to rebalance quarterly. By the second quarter of the year, assume the value of your stock shares has skyrocketed, and your portfolio now has 97% stocks and 3% bonds.
In this case, you’d sell some of your stock positions and purchase bonds until you reach that original 90%/10% allocation you started with.
Now, maybe you’ve determined that you’re better off with a 97% / 3% allocation (and that’s fine) but I don’t recommend flip-flopping based on whatever the market does. This will cause you to make poor investment decisions over time, so stick with a target allocation for two to five years if you can.
Keep up with your rebalancing intervals
After you’ve rebalanced, make sure you keep an eye on your investments regularly and stick to the cadence you decided on earlier to rebalance on a routine basis. Remember that you’re not always going to be up in your portfolio, sometimes, for instance, your stocks will have lost money, and your allocation will be lower than you want.
This is okay—in fact, it will happen, and it makes for a great time to buy more stock since stocks go “on sale.” Alternatively, you can avoid all of this hassle by choosing a robo-advisor.
How often should you rebalance your portfolio?
There are a few schools of thought on this, and frankly, there’s no right or wrong answer. The short answer: if you’re rebalancing on any regular cadence, you’re probably okay. That said, some strategies may work better for you in the long term.
A good starting point is to rebalance your investment portfolio annually, usually around the same time every year. There are a couple of benefits to this. First, you have a set time of the year when you look at your assets and make any necessary changes. This allows you to get into an annual rhythm. But there may also be tax benefits to doing this at the very end of the year (more on this below).
Another reliable option for rebalancing a portfolio is to do it each quarter. This makes sense because it’s more frequent than doing it annually, but still not too frequent. You don’t want to rebalance too frequently because it doesn’t always give your assets a fair chance to grow. Plus, if you invest in individual stocks, you can align your rebalancing to when most of the companies you’re positioned in release their quarterly earnings (which is when many investments tend to move up or down).
I don’t recommend rebalancing a portfolio every month for most people, but it can make sense for some. If you’re someone who has a lot of investments and a lot of riskier assets, then you might want to consider rebalancing monthly. For example, if you’re putting money into cryptocurrency, growth stocks, or any other type of investment that could be regarded as a short-term investment, I would suggest looking at and rebalancing more frequently.
Who doesn’t need to worry about rebalancing a portfolio?
There are two types of investors that don’t typically need to worry about rebalancing a portfolio:
Single-fund investors invest in either a target-date retirement fund or just pick a single index or mutual fund to invest in and continuously reinvest in that one fund. This is common for people who want a “set-it-and-forget-it” approach to investing.
For instance, you might choose a target-date retirement fund in your RRSP. By doing this, you can pick a fund that generally aligns with your anticipated retirement date, and the fund will change its asset allocation over time to match that retirement date (i.e., more bonds as you get closer to retirement).
Or, if you’re like me, you pick a single index fund that’s already got broad diversification, and you continuously reinvest in that single fund. For example, you might choose an S&P 500 ETF or index fund that gives you access to some of the biggest stocks in the stock market and just let that be your only investment.
There’s no need to rebalance your portfolio if you use a robo-advisor. A robo-advisor aligns a portfolio to your overall risk tolerance and investment objectives, then continuously rebalances that portfolio as needed to maintain the right asset allocation. Basically, it does all the work for you.
For example, Wealthsimple allows you to choose a risk level for your portfolio: between “Conservative” to “Growth.” Depending on this risk measure, the asset allocation will fluctuate. But as long as you stick with that risk level (and by the way, you can change it at any time), Wealthsimple will rebalance your investment portfolio periodically to ensure your portfolio stays aligned to the original asset allocation.
Depending on the robo-advisor you choose, you may also have access to an asset class you aren’t comfortable with, such as cryptocurrency. This is an excellent option since the robo-advisor will help manage your exposure and risk measures regarding that asset class. (By the way, Wealthsimple Trade now gives you access to crypto investing.)
Does it cost money to rebalance your portfolio?+
Do you pay taxes when you rebalance your portfolio?+
You may pay taxes when you rebalance your investment portfolio, depending on the assets you sell and when you sell them. If you sell a stock for a profit in a taxable investment account, you’ll be subject to a capital gains tax. In Canada, 50% of the value of any capital gains is taxable. However, you can offset this gain by selling investments at a loss, which is a viable tax strategy. For more information, consult a tax professional.
Knowing when it’s time to rebalance is essential—both in the short-term and long-term. Just make sure you have a strategy, and you stick to a routine and a risk tolerance you’re comfortable with. Over time, your returns should move in the right direction.