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Portfolio rebalance?
You started investing in mutual funds and ETFs, or perhaps individual stocks and bonds; great! The path to financial freedom begins somewhere, so, regardless of where you are, congratulations! Many markets are at all-time highs, and life is good.
However, unless you invest exclusively in target-date funds or a single total market index fund, you are now responsible for rebalancing your portfolio.
Unfamiliar with rebalancing? Rebalancing is the act of bringing your investments back to your original portfolio allocations.
Example: 70% stocks/30% bonds
Risk, Reward, & You
Investing is about taking on measured risks to pursue rewards, and every investor must understand how much risk they can tolerate.
Whenever you started investing, you likely decided on a specific amount of exposure to domestic and foreign stocks and bonds. By allocating a ratio of stocks to bonds, you set an expected range of risk and returns. If you didn’t do this or are unsure where your tolerance now lies, this post outlines the basics.
Now, I learn best by example, so let’s create a hypothetical situation to illustrate risk and reward: Assume that in 2011 you chose to invest 70% in stocks and 30% in bonds. Of your 70% in stocks, 49% were invested in domestic companies and 21% in international ones.
Statistically, your stock holdings should grow fastest if history serves as a guide.
Now, in our example situation, this is just the case: During the ten years between 2011 and 2021, you experienced the longest bull run in market history, and you survived the Corona Crash, all while staying invested; congratulations!
Assuming you did not add any additional funds, stocks would now make up ~83% of your portfolio, while your bonds would be a measly ~17%. Remember how your portfolio was original 70% stocks and 30% bonds? Well, the resulting change to 83% and 17% is what we call portfolio drift.
Portfolio drift naturally increases your returns over time. However, drift leads to substantially more risk as time moves on!
Proof of Increased Risk
A portfolio composed of 17% bonds compared to 30% bonds makes a significant difference in portfolio risk and fluctuations. Don’t believe me? If we look back at the past 25 years, a portfolio that was 17% compared to 30% bonds meant taking on 118% more risk. Such increased risk meant that when the markets went down, the lower bond portfolio experienced a drop in value that was 116% greater!
[This assumes both portfolios were rebalanced when straying by more than 5% to keep them at their approximate allocations.]
While the above example has worked out favorably for your net worth, it leaves you susceptible to situations where rapid and substantial fluctuations in your net worth can occur that exceed your comfortability levels. Additionally, this situation becomes increasingly problematic for portfolios more conservative than the 70% stocks/30% bonds portfolio illustrated.
Risk & Panic
Market drops are dramatic events, and if your portfolio falls more than you had expected or planned for, it can lead to panic.
I saw this first hand during the Corona Crash, where a myriad of investors I spoke to hadn’t factored in the possibility of such a change in their net worth. When you don’t plan around risk and reward, you leave yourself susceptible to panic. Increased panic leads to irrational thinking, and irrational thinking, unfortunately, can lead to selling your portfolio. Selling your portfolio means that you’re investing wrong and only hurts you, as time in the market matters more than timing the market.
Preferably, you will create a financial plan where rebalancing is a regular occurrence if you want to avoid such situations. Taking such steps helps keep you in an expected range of what fluctuations are possible. Thus, you become less likely to sell, resulting in a higher net worth over time.
How Often is Often Enough?
Rebalancing is something finance professionals regularly argue about regarding frequency and necessity. Needless to say, I believe in rebalancing, or I wouldn’t be writing today’s post.
History shows that rebalancing decreases risk while having a modest impact on returns. Do you need to rebalance daily, weekly, or monthly? No.
Instead, consider rebalancing at the year-end or whenever your portfolio drifts by 5%. Vanguard recommends this approach, as do many finance professionals.
I use the 5% drift method only because I don’t see a reason to rebalance due to the passing of x number of months. For some, though, rebalancing at the year-end can provide a review that they otherwise would not do, which is critical.
Reviewing your investments and making sure that you are sticking to your financial plan leads to success more often than not. Research clearly shows that those with a financial plan have 250% more retirement savings than those without one. So, choose a frequency or drift percentage that you are comfortable with and stick to it!
Final Thoughts
Rebalancing is a habit that leads to consistency, and consistency can help guide you to financial freedom. By taking measured risks in the pursuit of reward, you can outpace inflation, grow your savings, and live a less stressful life.
I see rebalancing in tax-preferred accounts, such as IRAs and 401(k)s, as a no-brainer since there are no tax implications of trading. However, for those investing in taxable accounts with substantially appreciated positions, the tax bill can be offputting. If this is you, consider rebalancing your portfolio only within your tax-advantaged accounts to reach your overall portfolio goals.
Regardless, I look forward to hearing about your strategies around rebalancing! Let me know in the comments below how frequently you rebalance your portfolio – if ever – and your reasoning. As always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time
