Don’t put all of your eggs in one basket; never bet it all on one roll of the die. Whatever proverb you pick, it all boils down to the same thing: minimizing the chance of heartbreak, sleepless nights and financial distress by finding the right balance between risk and reward.
Investors do that via asset allocation — building a balanced portfolio that contains a diversified mix of assets so that when one holding unexpectedly zigs, the entire portfolio doesn’t zig right along with it.
What it really means to diversify
Investors need both ziggers and zaggers to smooth returns over the short and long term. Without both, a portfolio will not be able to withstand various market climates and may swing wildly to and fro even when the overall market seems calm and collected.
Diversification hedges against risk by investing money across a variety of assets that don’t typically move in lockstep. You want a mix of things that are not affected by the same factors or in the same way or at the same time. That isolates the damaging effects of any single type of investment in order to prevent it from dragging down your overall returns.
Nerd tip
You can diversify your portfolio across:
- Asset classes: Stocks, bonds, cash.
- Industries: Consumer goods, energy, technology, health care.
- Company size: Large-capitalization, mid-cap or small-cap stocks.
- Geographic locations: Foreign companies or domestic ones that conduct a lot of business overseas.
- Investing styles: Mutual funds that invest in companies poised for rapid growth or ones that offer value; stocks that produce income (by paying out dividends).
The asset allocation model you’ve set will drift over time. Some investments will grow and become a bigger slice of your holdings while others will shrink. It’s natural for position sizes to morph over time. This is where rebalancing comes in.
Portfolio rebalancing strategies
Rebalancing simply means restoring a portfolio to its original makeup (asset allocation mix) by buying and selling investments. Simple concept, but sometimes complicated in practice.
An “investment portfolio” often means dealing with multiple portfolios — IRAs, 401(k)s, brokerage accounts, long-forgotten paper bonds locked away in vaguely remembered safe-deposit boxes. We’re talking about accounts set up at different times during your life, subject to different tax treatments and based on savings strategies from the days of yore.
Tracking all of your investments using software, an online portfolio tracker, or by having them all at a single financial institution certainly makes it easy to review your entire investment picture at once. (And if you invest using a robo-advisor, rebalancing is automatically included with account management.) But you don’t need to be an organizational guru to restore balance to your portfolio. Use one or any combination of these strategies to rebalance your portfolio:
1. The “While You’re at It” Strategy: Every time you either invest new money in the account (making monthly or quarterly IRA contributions, for example) or withdraw funds (if you’re already retired and drawing income from an account), tack on a bit of rebalancing housekeeping. Identify underrepresented or over-weighted asset types in your portfolio; then you can beef up your position with each contribution check or lower your exposure with withdrawals.
Depending on the size of your portfolio, you may not be able to accomplish all the rebalancing work that needs to be done. In that case, augment your homework with one of the other strategies.
2. The “Home Base” Strategy: Are most of your retirement assets contained in a single account, like your 401(k) or an IRA to which you rolled over money from your former employer-sponsored plan when you left the company? Well, that’s convenient. Make that account your rebalancing mothership, since what goes on in there has the biggest effect on the overall health of your savings. Even better if it’s a tax-advantaged account, because selling within the account won’t generate any short- or long-term capital gains taxes.
Although you may have one “main” portfolio, don’t completely ignore the role played by assets in smaller satellite accounts, especially if the holdings in those portfolios are particularly concentrated. For example, if you’ve got a separate brokerage account where the majority of investments are in growth stocks, your exposure to similar investments in your mothership account may need to be trimmed to make the entirety of your assets balance out.
3. The “I Treat All My Children the Same” Strategy: Got multiple investment accounts with similar amounts in each? Treating each as a separate, fully balanced portfolio may be the way to go.
Decide on your target asset allocation mix and then deploy the same strategy in each. Depending on the investment selection in each account — e.g. your 401(k) fund options versus the wider assortment in a self-directed IRA — you won’t necessarily be able to invest in the exact same mutual fund in each account. Just look for a fund that offers similar exposure or has the same investment objective. Consider each account’s tax status and investment fees so you can minimize what you pay out of pocket or to the IRS.
4. The “Sweat the Biggest Stuff” Strategy: U.S. large-cap stocks are the biggest slice of the pie in most investors’ portfolios. Therefore any shift — whether a giant sneeze or a momentary sniffle — can create a seismic shift in its original allocation. The good news is that it’s easy to identify the culprit throwing things out of balance. If you notice any major shift from your original allocation plan, check your large-cap stock positions first to see if the drift can be smoothed out by shifting money among those funds.
Another thing this strategy has going for it is the built-in tax efficiency of many U.S. large-cap stocks and large-cap-focused funds, making it a more cost-efficient way to rebalance. Remember: The more you can avoid investing fees (such as transaction costs) and taxes, the more of your money is left to compound over time.
How often and when to rebalance your portfolio
Now that you know how to rebalance, the question is: when?
In April (tax time) or December (tax-loss harvesting time): Let the calendar be your guide. Many investors rebalance when they’re doing other financial housekeeping tasks, such as preparing their taxes. Alternately, the end of the year is a good time to take advantage of tax-loss harvesting maneuvers to offset taxable gains that selling might trigger.
When an investment shifts more than 5%: Many investment pros recommend rebalancing when the performance of a single asset shifts more than 5%. The 5% rebalancing threshold is a good rule of thumb, but be careful about monkeying with your asset allocation mix too much (for instance, reacting to a short-term price movement). Doing so puts you at risk of locking in your loss when you sell and missing out on potential gains when the asset recovers.
Almost never: A Vanguard paper on the best practices for portfolio rebalancing back-tested four different rebalancing scenarios — monthly, quarterly, annually, never (solely redirecting investment income back into the portfolio) — between 1926 and 2009 in a portfolio that held 60% stocks and 40% bonds. It calculated average annualized returns, portfolio volatility and costs (by measuring the number of rebalancing events).
Vanguard’s findings? Rebalancing more frequently than never had no material impact on a portfolio’s volatility. In fact, the less frequently the portfolio was adjusted — other than reinvesting the portfolio’s dividends and interest payments — the better the return.
Rebalancing Effects 1926-2009
| Monitoring frequency | Monthly | Quarterly | Annually | Never |
|---|---|---|---|---|
| Minimum rebalancing threshold | 5% | 5% | 5% | None |
| Average equity allocation | 61.2% | 60.9% | 60.7% | 84.1% |
| Annual turnover | 1.7% | 1.7% | 1.6% | 0% |
| Number of rebalancing events | 58 | 50 | 28 | 0 |
| Volatility | 12.2% | 12.1% | 11.8% | 14.42% |
| Average annualized return | 8.6% | 8.8% | 8.6% | 9.1% |
Source: Vanguard, “The Best Practices for Portfolio Rebalancing”
The lesson here is that rebalancing is about managing risk and not chasing returns. And, more practically, that rebalancing your portfolio once a year is plenty … and less frequently may be even better as long as your portfolio is truly diversified from the outset.
Remember, rebalancing is not about completely overhauling your portfolio. Major strategy shifts in your asset allocation plan should be infrequent and only in response to major life changes (getting closer to retirement) or shifts in investing goals (increasing liquidity for potential expenses or shifting into income-generating investments).
Rebalancing is meant to be restorative. Giving your portfolio enough breathing room to grow while keeping an eye on its overall health is the best rebalancing strategy of all.
More tips on rebalancing and managing your portfolio:
- 5 steps to rebalance your 401(k) like a pro
- How to invest your IRA
- Turn loser investments into a tax break
Dayana Yochim is a staff writer at NerdWallet, a personal finance website. Email: DYochim@nerdwallet.com. Twitter: @dayanayochim.
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