When, Why and How to Rebalance Your Portfolio

The COVID-19 pandemic has reminded investors of the value of rebalancing portfolios. People approaching retirement – certainly, retirees – should be more inclined to rebalancing from equities to bonds.

For most of my life I’ve fretted more about inflation than rebalancing, but age has a way of redirecting one’s thinking.

Why Rebalance?

History shows that redeploying equities into bonds does, in fact, contribute to tempering a portfolio’s volatility. But there are other reasons for rebalancing, too… reasons aside from volatility (risk) reduction. Folks already in retirement might need to convert stock into cash to meet increased living expenses. This accomplishes two purposes: volatility reduction AND cash flow enhancement. Younger investors might derive certain benefits by increasing risk via adjustments in equity shifting within their own asset groups (growth to value, domestic to international, dividend chasing, etc.).

Flirting With Rebalancing

Those wild inflation years in the late 70’s and early 80’s instilled in me a cautious nature regarding the erosion of purchasing power. I knew that rebalancing could deliver multiple benefits, but I put it off… still do to a certain extent. Face it, the stock market has been a good place to be since the mid-1980s, and there is a natural aversion to monkeying with a positive trend. I also debated about what a proper portfolio balance might be at given points in time – and whether the rebalancing effort might trigger unnecessary tax events, reducing net yield over time. Most of my early rebalancing efforts were within my own portfolio’s asset groups… small-value to mid- or large-, value to growth and back, individual stocks to funds (mostly index), but truth be told, most of my shifting was from individual stocks to low-cost mutual funds to gain diversification. These are all legitimate rebalancing choices and can reduce risk and enhance portfolio yield.

Where To Start

If, like me, you’ve been flirting with rebalancing but just aren’t certain when or where to start, here are some things to consider. Start with what’s motivating you to even consider rebalancing in the first place. Is it because retirement is at hand and risk reduction is of major concern? Are you worried about today’s generous market valuations? Has the market’s recent volatility given you more heartburn than usual? Perhaps, then, a movement from stocks to bonds is the right strategy for you – a reallocation that will likely reduce risk but NOT necessarily enhance returns. Over time, a stock-heavy portfolio traditionally outperforms one emphasizing bonds.

After considering your primary motivation for rebalancing, take a hard look at your existing portfolio (including real estate) and your stage in life. If you’re a new retiree with a portfolio heavy in equities, you are particularly vulnerable to a market decline. That comforting paycheck is gone but spending for day-to-day necessities remains a part of life. There is no worse time to experience a bear market… and no better time to comfortably shift more equities to bonds and cash (that Rainy Day fund) and to appreciate that inflation-adjusted Social Security check. If you’re still a bit light on day-to-day cash, this also might be a good time to convert a portion of those equities into an annuity – but use prudence about those non-inflation adjusting annuities. If you’ve been a reliable saver, Required Minimum Distributions (RMDs) are very much a part of your future, but if possible, don’t tap them until “required” (age 72). Avoid early draw downs of any source of capital… a key to your portfolio’s sustainability. Remember, it’s not uncommon to spend two or three decades in retirement.

Target-Date Funds

By the way, if you’re like me and tend to procrastinate about rebalancing your portfolio, don’t forget the previously mentioned Target-Date Funds for all ages – funds that automatically rebalance across the years (until they match the Target Retirement Income Fund allocation). I’m not suggesting that you go whole-hog into target-date funds, but their presence in a portfolio will provide some comfort despite a malingering nature. For younger investors, low-cost, highly diversified target-date funds invest heavily in domestic and international stock funds and give lighter weight to domestic and international bond funds. As the years go by, those positions gradually reverse. I joined the target-date crowd later in life as my inflation-neurosis calmed a bit in the face of my ever shorter time horizon. With some target-date funds in hand, I now feel more at ease with chaotic markets.

Benchmarking

It’s important that an investor have a meaningful blueprint by which to measure his or her investment successes, particularly when engaging in routine rebalancing. Comparisons to a benchmark will provide you with a better feel for what kind of rebalancing has worked for you over time. Since my primary objective to keep things simple – and because my portfolio is built around index funds – my benchmark is the S&P 500. Simple, yes, but a gauge that works for me.

Tax-Sheltering

Rebalancing necessarily involves buying and selling securities of one sort or another – activities that can lead to tax consequences. Accordingly, it makes sense to rebalance to the extent practicable within your tax-sheltered retirement accounts. For example, in an IRA brimming with low-cost Vanguard products, two things are avoidable: taxable events and high transaction costs. The same might be said for an employer’s 401(k) or 403(b) retirement vehicle, except fees tend to be a bit higher.

As to those taxable accounts, if yours is equity-heavy – and retirement is on the horizon – in lieu of triggering a tax bill explore the possibility of investing monthly contributions in underweighted (i.e., bonds) areas. If retirement is at hand, follow the “specific identification method” of selling winners… simply earmark your high-cost-basis units for sale versus the lower-cost-basis units… an effective way of minimizing capital gains.

Retirees 'n Rebalancing

Rebalancing an individual’s portfolio from stock to bonds – particularly in or near retirement – is clearly a risk reducer but is less rewarding from a yield perspective. Stocks tend to be more volatile and routinely outperform bonds. But stage in life is important when considering rebalancing. Typically, younger investors worry less about controlling risk. Because time is on their side, generating higher returns take precedence… and rebalancing takes a back seat.

I recall those years of making routine contributions to retirement accounts heavily weighted with equities. Volatile markets bothered me less than low yielding investments. And I must admit that this practice of not rebalancing can become a habit in the pursuit of higher yields… even in retirement. So, let me emphasize the importance of rebalancing as retirement nears. With less time for recovery from major market declines, risk reduction becomes increasingly important – more so than in those early years of asset accumulation. And as mentioned earlier, rebalancing can help with cash flow sourcing, diversification, tax avoidance, and if you’re so inclined, charitable giving. Give it some thought.