Investment portfolios are like vegetable gardens. You have to “prune” them periodically in order to keep them healthy. You do that by rebalancing your investment portfolio.
If you use an investment manager or a robo-advisor platform to invest, you won’t ever need to worry about when to rebalance your investment portfolio. Your service will take care of everything for you.
However, if you’re a do-it-yourself investor, you’ll have to handle your portfolio maintenance yourself.
In addition to keeping your asset allocation healthy, rebalancing is the best way to take advantage of “buy low, sell high.”
When you rebalance, you buy into positions that are undervalued while selling ones that have reached their peak at the same time.
So when should you rebalance your investment portfolio? There are different ways to time it, and you can use whichever method works best for you.
Let’s take a look at some of the times when a rebalance should be in the cards.
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A Change in Your Risk Tolerance
While you might think your risk tolerance stays pretty much the same throughout your life, the truth is it can change due to a number of factors.
For example, your risk tolerance is likely to go down as you get closer to retirement. Fearing the loss of investment assets when you’ll soon be needing them, you might become more conservative and invest more heavily in fixed-income investments.
By contrast, your risk tolerance might go up if you were to come into a large windfall of money.
It’s impossible to describe all of the circumstances in which your risk tolerance might change. But when it does, it’s likely you’ll need to rebalance your investment portfolio to optimize your asset allocation.
A Change in Market Conditions
Another good time to rebalance your investment portfolio is when the market makes an extreme move in either direction. (Now, know that this is controversial because it could be interpreted as an attempt to time the market.)
For example, if the stock market seems excessively high, you might want to reduce your exposure to stocks and move more money over to safer assets such as Treasury bonds.
At the opposite end of the spectrum, after a long downtrend in the market, you might be interested in rebalancing in favor of greater exposure to equities. That will give you an opportunity to earn bigger returns as the market begins to recover.
Keep in mind that, in both of these situations, you should never completely abandon either equities or fixed-income investments. However, you can change your investment allocations to be consistent with what you see happening in the market.
A Change in Life Events
Any major change in your life is likely to affect your risk tolerance and the way you allocate your portfolio.
This is another extremely broad category, since the possibilities are endless.
For example, the birth of a child might convince you to rebalance your portfolio in favor of more fixed-income investments. This way, you can reduce the overall risk in your portfolio.
However, some investors might take the exact opposite approach and invest more heavily in stocks in anticipation of higher future expenses such as education.
The onset of a major illness or the loss of your job can also cause you to take a more conservative approach to investing. You might also be more interested in fixed-income investments if you’re starting your own business, since the business itself is likely to be riskier than a steady full-time job.
And naturally, you’ll be more interested in increasing your equity holdings if your goal is to retire early.
Based on Percentage Changes in Your Portfolio Allocation
You can set certain percentage allocations in your portfolio. As they are exceeded – based on a certain predetermined percentage – you automatically rebalance.
This is probably the most common scenario for rebalancing. It also has the advantage of taking the emotion out of your rebalancing efforts. The process becomes mechanical, and emotional factors are excluded from your decisions.
You can set whatever percentage variance in your portfolio you want. For example, if you have 70% of your portfolio invested in stocks and 30% in fixed income, you might decide to rebalance anytime either allocation changes by, say, 5% or more.
In that situation, if the balance in your portfolio went to 75% stocks and 25% fixed income, you would rebalance by moving 5% of your portfolio from stocks over to fixed income.
On the flip side, were the market to drop, and stocks fall to 65% and fixed income to 35%, you would move 5% of your portfolio from fixed income into stocks.
You can set any percentage limit you like, but 5% is probably the most common. Of course, fees can be a concern here. The more frequently you rebalance, the more investment fees you’ll incur.
For that reason, you might set a higher percentage threshold, particularly if your portfolio is on the smaller side. In that situation, 10% wouldn’t be unreasonable.
At Regular Intervals
You can simply decide that you’re going to rebalance your investment portfolio based on a particular timeframe.
This is probably the simplest rebalancing strategy because it virtually eliminates emotion and even hesitation from the picture.
Rebalancing on a quarterly basis is probably the most common strategy. But if you have a very large portfolio, it may make better sense to rebalance on a monthly basis.
Again, fees are something to consider. If you rebalance too often, you’ll increase those fees.
Once again, your portfolio will be set up with certain percentage allocations that you’ll attempt to retain by periodic rebalancing. You’d make changes only if there were significant variations in your portfolio allocation.
You might even consider doing periodic rebalancing in combination with percentage changes. For example, you might plan to rebalance your portfolio on a quarterly basis, but only if there are percentage variations that exceed a certain percentage, such as 5% or 10%.
When to Rebalance Your Investment Portfolio: The Bottom Line
Rebalancing is a mission-critical part of investing and something you need to stay on top of. Pick a method that works for you and implement it as necessary.
It’s particularly easy to ignore your asset allocation when the market is flying high. But should the market reverse in a major way, you’ll be looking back and asking yourself why you didn’t rebalance your investment portfolio while you had the chance.