The Importance of Balancing and Rebalancing Your Investment Portfolio

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Balancing your portfolio deals with three important aspects to consider for your investments:

• Risk—Seek to balance risk and return. Your willingness to take risks may be greater when you’re younger and have more years to correct from choices that may turn out to be money losers. As you get older, you are likely to reduce the amount of risk you are willing to tolerate, given you don’t want to jeopardize your principal amount of savings needed for retirement.
• Returns—Interest rates can be low in one period, higher in another. Stocks can appear cheap today, and then tomorrow the market turns frothy and speculative. Bonds, long-term, rose for decades as interest rates were suppressed and decreasing, then fell hard when inflation forced interest rates back up. What was once considered conservative for decades became risky in the past several years.
• Diversification—This is a strategy of buying different types of investments to reduce overall risk and volatility. There are many new and various investment vehicles and options being offered to investors.

Your initial investment strategy requires that you choose how to allocate your assets; for example, you may want 70 percent of your portfolio in stocks and 30 percent in bonds. When you fund your portfolio in this manner, it is considered—at least initially—a balanced portfolio.

Over a period, these allocations don’t stay the same. If the stock market doubles over five years, but bond interest rates and principal amounts didn’t change much, your initial portfolio of 70/30 has mathematically changed to 82.3/17.6. Time to lighten up on stocks and move more into bonds—that is, assuming your overall strategy hasn’t changed. As we age, we would generally find our bond allocation should grow, not decrease. One way to view bonds is the interest is the (in part) cash flow replacement for the paychecks we received before we retired.

Rebalancing must also address stocks within the entirety of your stock allocation. If one stock becomes “overweight” in your portfolio, this new risk is called “concentration,” and can be a good reason to lighten up on the stock where you have enjoyed the greatest gain. That can be difficult when it comes to selling a stock that has been very good to you! Likewise, the landscape may change for bonds. Today, short-term U.S. Treasurys pay over 5 percent interest, while long-term bond principal values have been falling in concert with increasing interest rates.

There is neither a perfect method nor ideal diversification strategy for every balanced portfolio. One size does not fit all. Degrees of risk aversion, your age, the total of your investments, and several other factors go into the design of your own portfolio diversification strategy.

One method for coming up with your personal asset allocation is called the Rule of 110. Begin with your chronological age, subtract your age from 110, and this provides the percentage of your portfolio to allocate to stocks, with the remainder mostly going to bonds. As an example, let’s say you’re 40 years old. This means that about 70 percent of your portfolio should be in stocks and the other 30 percent in bonds. As you age, more of your portfolio should become allocated to bonds, both for safety and for the cash flow to replace your loss of paychecks when you retired. When my mother was in her seventies, virtually all her portfolio was in bonds.

When Should You Rebalance Your Portfolio?

There are two ways to approach rebalancing. You can rebalance your portfolio based upon timing (end of each year, for example), or you can rebalance your portfolio when it becomes clearly unbalanced and out of sync with your strategy.

A Common Trap to Avoid

When market values crater, we want to sell our holdings before conditions worsen. And when market values are going up—and you’re making money—that’s when we want to plow our money into the market. That is the opposite of buying low and selling high, and although fear and greed will tempt you, you must resist these emotions and continue with your strategy and portfolio plan.

Let’s say the stock market crashes and stocks lose 30 percent of their value; then your bond allocation has become too high. Restoring balance will involve selling some of the bond investments to buy stocks while they’re “cheap.” A balanced portfolio strategy, diligently followed, will preclude knee-jerk reactions based upon emotions such as fear and greed.

We all have heard the admonitions: “Don’t put all your eggs in one basket“ and ”Never bet all on one roll of the dice.” It boils down to doing your best to find the right balance between risk and reward, again reflecting your own risk profile—from riverboat gambler to conservative and unwilling to lose any of your principal investment.

Beyond the Broad Categories of Stocks, Bonds, and Cash

Diversification hedges (insures) against risk by investing money across various assets that don’t typically move together in the same direction or at the same time to the same magnitude. That reduces the possibility of any single type of investment dragging down your portfolio and with it the overall returns. It also reduces your upside total potential overall, unfortunately. Some factors to consider include:

• Asset classes: Stocks (individual, indexed funds, exchange-traded funds), bonds (short and long term, junk and blue chip), cash (money market, CDs)
• Company size: Large-capitalization stocks (such as those in the S&P 500 Index), and mid- and small-cap stocks (such as those in the Russell 2000 Index)
• Industries: Consumer goods (e.g., retail companies), energy (oil companies), technology (AI, e.g.), health care (HMO, pharmaceuticals)
• Geographic locations: Not only foreign companies but also domestic multinationals that conduct business overseas
• Styles of investing: Growth stocks, dividend-paying stocks, U.S. Treasury bonds, tech startups, auto companies with good electric vehicle models, etc.

Portfolio-Rebalancing Strategies

Rebalancing means restoring your portfolio to the original model (asset allocation mix) through the process of buying and selling investments in your portfolio. Your aggregate “investment portfolio” could involve multiple financial accounts, including Roth IRAs, 401(k)s, brokerage accounts, and U.S. Treasurys. One or more of these strategies can be used to rebalance your portfolio:

• For each new investment, you should quickly reanalyze whether it’s ‘in balance. Flag the under- or over-weighted asset types and make the required shifts in your investments.
• If most of your retirement assets are in a single account, like a brokerage or a retirement account (I personally have one of each), it is easier to rebalance even if you’re mostly focused on the larger of the two accounts. In the case of your brokerage account, you are also dealing with interest and dividends income, along with capital gains. In your retirement account, unless it is a Roth IRA, you will pay income taxes on your retirement withdrawals (401(k), IRA).
• U.S. large-cap stocks are the biggest piece of the investment pie in most investors’ portfolios. (With regard to market capitalization, a large cap, for example, is a company worth more than $10 billion.)

Rebalancing a Portfolio Also Comes With Some Disadvantages

• Transaction costs reduce net income (via commissions, e.g.)
• Selling securities increasing in value may mean you miss out on an upward price trend.
• Investing knowledge and experience is essential to reduce exposure to risk; this includes practice and time.
• You may be subject to possible short-term capital gains taxes—that is, on stocks held and sold in less than one year.

Just as experience, including the regrets from your mistakes and misallocations, will be your best teacher, get started early so you have many years ahead to develop your rebalancing skills.

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