The nine-year bull market has helped fatten most investment portfolios, which is a welcome relief for many investors who have lingering memories of the Great Recession. However, the bull market may have also created a rebalancing “problem” that some investors are reluctant to fix because they don’t want to miss out on returns. Of course, high returns are not a bad thing by any stretch of the imagination, but they do create a challenge nonetheless.
Because of a little thing called rebalancing.
What is Rebalancing?
If you’re unfamiliar with the term, rebalancing essentially means keeping your investment portfolio in line with your long-term strategy. If you have a diversified investment strategy, then you most likely selected a mix of assets that matched your long-term goals. To maintain that same ratio of stocks, bonds and other assets, you need to periodically rebalance your portfolio by redistributing your funds so the original proportion remains consistent.
Here’s a simple example: Let’s say you allocated your investments to a simple 70-30 mix with 70% stocks and 30% bonds. Over time, this 70-30 split becomes unbalanced due to the differing performances of stocks and bonds. This shift alters the risk level in your portfolio and, to keep your risk aligned with your financial plan, must be readjusted on a regular basis—usually annually.
During the prolonged bull market, stocks have far outperformed bonds, so a portfolio that has not been regularly rebalanced is likely strongly skewed toward stocks—and may be more risky than the investor may have intended.
Why Should You Rebalance Away From Strong Returns?
Given the long-term strength of the stock market, you might think that if stocks are doing well, you should let them ride. Why not stick with winners, right? That’s where the resolve comes in. It can be very difficult to consider selling high-flying stocks to invest in limp-along bonds, for example. In fact, some investors choose to stick with high-producing investments despite the imbalance issues this causes.
Unfortunately, this decision could create future problems for your overall financial plan. Let’s say stocks now represent 85% of your portfolio, up from the 70% you prefer. If the stock market drops, your assets could take a much bigger hit than you originally expected. To rebalance, you must sell sufﬁcient stocks to reduce back to 70% and then use the proceeds to buy bonds to increase that allocation. In fact, if the stock market continues to rise, you will need to keep selling to maintain your original stocks-to-bonds allocation. At one level, it doesn’t seem to make much sense to sell successful assets to buy less successful assets, but there are some very good reasons for maintaining your preferred asset mix, including:
- Rebalancing increases your opportunity to sell at the top and buy at a low—something all successful investors strive to do.
- Locking in profits along the way prevents you from losing, possibly overnight, much of your paper gains.
- Keeping your asset mix in line helps keeps volatility in check because your portfolio maintains its diversification.
The key is to establish a diversified investment portfolio that fits your personal investment style, your risk-tolerance level, and your long-term goals. Then stick with it — rebalancing as needed to maintain your specified asset mix.
Here are some basic rebalancing steps:
- Don’t worry about minor imbalance. You’re looking to rebalance on, approximately, an annual basis or when your asset balance is off by a significant amount, which will depend on your overall allocation to each asset class.
- Look for ways to rebalance that will harvest profits. For example, you can simply prune positions in certain stocks that have done well, if you have individual stocks in your portfolio.
- Be mindful of the tax consequences, if you are rebalancing a taxable portfolio. For tax reasons, you may want to sell in ways that match losses and wins to keep taxes at a minimum.
- Consider the overall diversification of your portfolio, so that your ending asset mix fits your desired asset-allocation strategy. Enjoying bull market returns is gratifying, but your long-term strategy should be your utmost concern.
A professional financial advisor can help you modify your strategic investment plan to maintain your optimal asset mix and keep your portfolio balanced.
Craig Birk, CFP®
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