Rebalancing your portfolio at least once a year is a good practice to make sure you aren't getting too overweight or underweight in any allocation.
Why Rebalancing Is Important
Your portfolio allocation is your plan to address your risk and investment goals. You chose it to be diversified into these specific investments. The percentages of each category are set to match your risk tolerance and investing goals. If you get too overweight or underweight in any of those categories, you may be exposing yourself to too much risk.
Your investments may be divided by asset class, cap weight, international, REITs, stock sector, or any combination of the above. You might find it helpful to review how to choose investments and how to build a portfolio.
Becoming unbalanced is inevitable if you have more than one investment in a portfolio because your investments grow at different rates. In fact, a well-designed portfolio will become unbalanced by design. You have specifically chosen assets that are not correlated so that your investments are not affected by a single influence. If your investment is doing well, you will become overweight in this investment. Conversely, if your investment is doing poorly, you will become underweight in this investment.
Rebalancing forces you to sell the investments that are doing well to buy investments that may not be doing as well. While this may seem like a bad thing, you are following the timeless advice to buy low and sell high. It goes against most investors' psychology, but it is an essential strategy for building wealth over time and not reacting to market changes out of fear.
How to Rebalance Your Portfolio
You can use the Portfolio Rebalancing Journal to keep your rebalancing information organized as you run the calculations and go to your brokerage website to execute the trades. The first step to rebalancing your portfolio is to write down your overall portfolio balance and the target percentages for each investment.
Next, plug in the balance of your total portfolio and the investment you want to rebalance into the Portfolio Rebalancing Calculator. Enter the target percentage of that investment as a decimal. The calculator will tell you the target dollar amount of that percentage.
The calculator will also give you a positive or negative number to buy or sell. A positive number means you need to buy the dollar amount of that investment to be rebalanced. A negative number indicates that you need to sell that dollar amount to be rebalanced. Enter all of these numbers on the worksheet in the Portfolio Rebalancing Journal. Make sure you check whether to buy or sell the amount in the last column.
Do this calculation for each investment. Once you have all the numbers written down, you can buy and sell the investments. Some brokerages will allow you to do an exchange of funds or ETFs. If you sell and then buy assets, allow the money from sales to be transferred to your settlement account before you purchase new assets to avoid trade violations. You can read more about buying and selling stocks here.
When to Rebalance
Rebalance your portfolio at least once a year so your allocation doesn't drift too far from your target allocation. You can rebalance more than once a year, but limit your rebalancing to no more than once a quarter. It is okay for your portfolio to be slightly off-balance because the market is always changing. Some investors rebalance when their allocation drifts at least 10%. Whatever method you decide on, don't overdo it, and don't stress about it too much. Just make a schedule or rule and loosely stick to it. Over time, you may change your allocation as your risk tolerance changes or as you get closer to your investment goal.
Tax Consequences
If you are rebalancing a taxable account, you should consider the tax implications of rebalancing your portfolio and plan accordingly. In a tax-advantaged account, rebalancing does not trigger any tax consequences.
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