The New Year is a perfect time to “Re-Balance”

What is portfolio rebalancing? Put simply, the act of rebalancing ensures that your portfolio stays within your desired allocation over time. This is necessary because the assets in your portfolio will naturally change in value over time and the percentage relationship with one another will change as a result.

A “middle of the road” investor who starts off with a 50/50 mix of stocks and bonds may experience substantial appreciation over time with the stocks moving higher.

If all our assets appreciated by the same amount, there would be no need to rebalance. A 50/50 mix of stocks and bonds would still stay a 50/50 mix of stocks and bonds over time. The only difference would be the overall value. Since assets will perform at different rates, it’s likely that over time our mixture will change beyond the initial allocation we preferred. The investor is most likely happy to have experienced the increase in value of one asset class, however the current portfolio allocation may not be a good fit for his/her risk tolerance. Rebalancing can get things back in order by trimming a bit of the highest performing assets (the stocks in this case) and purchasing additional bonds.

Of course, properly implementing a portfolio re-balancing strategy assumes the investor has an overall asset allocation strategy for their portfolio in the first place. Too many individual investors evaluate individual investments one by one, selecting those they are attracted to, but not considering how the investments work together with one another. They can end up with a portfolio that is arbitrary, made up of many individual holdings that do not necessarily combine to create a proper allocation.

There is no specific reason why an investment has a place in the portfolio and just as importantly, why the specific position size was chosen. This can make it very difficult to reach specific financial objectives and difficult to manage risk. An effectively designed portfolio is not simply about choosing individual investments that you favor. Each investment most likely has merits that led you to consider it, but there may be no reason for all the investments to be owned together as a portfolio.

To properly allocate your portfolio you’ll want to do a financial plan that addresses what your needs and goals are for the future and then select investments that best match those needs. You will select an initial asset allocation that you will periodically rebalance to – unless a change in your future goals indicates a different allocation is more appropriate. A key point to understand is that you are doing all of this while attempting to take the least amount of risk necessary to meet your goals.

Make sure your initial allocation meets your needs for withdrawal or liquidation in the future, as well as any current needs such as a desire for income, as well as any tax implications relevant to your situation.

Now that understand the importance of having a solid initial portfolio allocation, and believe it is important to regularly re-balance back to that initial allocation, how do you decide when to rebalance? For many investors, an annual rebalance is a good choice. This allows your portfolio to be altered frequently enough that it still meets your investment objectives while not so frequently that it creates unnecessary transaction costs or tax implications. Each year, you can look at your portfolio and sell enough of the assets that have appreciated disproportionately to the overall portfolio, purchasing additional assets that have not experienced as much appreciation since the last year.

While an annual rebalance might be a good starting point, it is possible that during the year certain assets might move enough to warrant action before. There are also certain situations that might warrant changing your plans. Sometimes taking a large capital gain in the current year from the sale of a specific asset when there are not adequate losses to offset the profit can be minimized or deferred until the following year if a lesser tax burden is expected.

The process of portfolio rebalancing can be complex. You’ll need to consider when and under what conditions to rebalance. Depending on your accounts, you may be doing all of this while either adding to or withdrawing from the portfolio. This can be a challenging process that some investors have the time for and enjoy performing themselves. However, others find they might need professional guidance with designing their portfolio allocation and rebalancing it over time. They may also need assistance identifying their future needs within the context of an overall financial plan that also addresses taxes and other relevant issues that can be affected by these and other portfolio decisions.

If you’d like to discuss how to effectively rebalance your portfolio as well as how this decision may fit into several other aspects of your financial life, please reach out to the team at YHB Wealth and they will be happy to assist you.