What Is Portfolio Rebalancing? Here’s What You Need to Know

When you first start investing, most of the advice is centered around a few key points. One common aspect of investing is the concept of diversification. The idea is to use different financial tools to help protect against ups and downs. The amount that you keep in different types of assets—like stocks and bonds—is known as your asset allocation.

But over time, as some investments gain value while others lose value, your asset allocation might drift away from its targets. If so, your portfolio could take on more risk than you are comfortable with—opening the door to much greater swings in value. Or it might mean that you’re not taking enough risk, and that by being too conservative you are unlikely to hit your growth goals.

You can check whether your portfolio is still on target. If needed, you can make adjustments by portfolio rebalancing.

Below, you can learn more about what portfolio rebalancing is, how it works and some common strategies. You can see the potential drawbacks that can come from rebalancing too often and how to get help with rebalancing.

What is portfolio rebalancing, and how does it work?

Portfolio rebalancing is the process of bringing your mix of assets back to their target levels. You typically buy and sell assets to get back on target.

Let’s say you’ve got a traditional 60/40 portfolio with 60 percent stocks and 40 percent bonds. A year goes by, and stocks do really well, while bonds underperform. You’re left with an asset allocation that is closer to 70 percent stocks and 30 percent bonds. At this point, your portfolio has strayed from the target you set.

To rebalance the portfolio, you’ve got two options. The most traditional way to do this is to sell some of your stock holdings and then use that money to buy bonds. But if you’ve got available cash, you could buy more bonds without selling stocks. Either way, your goal is to return to the 60/40 target.

Here are some reasons to rebalance:

• to manage investment risk

• your investment timeline changes and you need your money sooner or later than originally expected

• your risk tolerance shifts and you find yourself more or less comfortable with risk

• your outlook changes and perhaps you think stocks are overvalued

Types of portfolio rebalancing strategies

You can use a strategy to guide when and how you rebalance. Below are some common portfolio rebalancing strategies to consider.

Calendar-based rebalancing

With calendar-based rebalancing, you review your portfolio at set times. Then you decide whether rebalancing is necessary. This way, the calendar is your reminder.

You could set up a review anytime from every month to every year—or even every three years. How often you rebalance your portfolio will depend on things like the tax implications and trading costs.

Percentage-based rebalancing

With percentage-based rebalancing, you adjust your portfolio any time your holdings veer too far away from their target. You can work with a financial advisor to help figure out what “too far” means for you. The amount of flexibility is called a “tolerance band.” Rebalancing is triggered when your portfolio’s allocation strays outside of these bands.

For example, let’s return to the 60/40 portfolio mentioned above. If you’ve set tolerance bands of 5 percent, you’d rebalance whenever the allocation to stocks drops below 55 percent of the portfolio or over 65 percent.

Automatic portfolio rebalancing

Automatic rebalancing is an option offered by some financial institutions. It involves the broker or advisor automatically adjusting your portfolio on an ongoing basis.

Rebalancing is automatically built in to target-date funds, which are very popular investment vehicles for retirement savings. They automatically rebalance to become more conservative as an investor gets closer to the target date (usually retirement).

What are the disadvantages of rebalancing your portfolio?

As mentioned above, portfolio rebalancing offers potential benefits, including the ability to correct course when asset allocation gets too far off track. But it can also have drawbacks, especially when you rebalance too frequently.

Rebalancing can cost money

When you rebalance your portfolio, you’ll need to buy and sell assets. If your portfolio is invested with a brokerage or wealth manager that charges transaction fees, you’ll trigger those fees every time you make a purchase or complete a sale. These fees could add up, reducing the amount of money you’ve got invested.

This is one reason to be cautious about rebalancing your portfolio too frequently. The more often you rebalance, the more transaction fees you may get charged.

Rebalancing can create tax implications

When you sell an investment for a profit, as you’ll often do while rebalancing your portfolio, you’ll be on the hook for capital gains taxes. These taxes can eat into your portfolio. If you held an asset for less than a year before selling, you’ll be taxed according to your ordinary income tax bracket. If you held the asset for more than a year, you’ll pay the more favorable long-term capital gains tax rate.

The good news is that there are various methods available to reduce taxes. If you’re dealing with assets held in a tax-advantaged account like a 401(k) or IRA, for example, you don’t really need to worry about capital gains taxes because you aren’t taxed until you make withdrawals during retirement. If you’re investing through a brokerage account, on the other hand, you can engage in tax-loss harvesting—selling losing assets to offset your gains—to minimize taxes.

Rebalancing can reduce returns

Rebalancing will often involve selling a portion of your assets that are performing well. While this can help you “lock in” some of your gains, it can also reduce your potential for future growth—especially if those high performers continue to perform well.

While this may seem like a negative, it’s important to remember that you have an asset allocation for a reason. While you may miss out on some returns, you’re also protecting yourself if your investments lose value—which is always a possibility.

Rebalance your portfolio regularly

Whether you invest on your own, work with someone who is managing your investments or anything in between, it’s good to understand the concept of rebalancing. Monitor your portfolio and take steps to rebalance it as needed.

Your Northwestern Mutual financial advisor can answer questions about rebalancing investments. Your advisor can also help you set your asset allocation and stay close to your target.

All investments carry some level of risk, including loss of principal invested. No investment strategy can assure a profit and does not protect against loss in declining markets. This article is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.