How and When to Rebalance Your Portfolio

Rebalancing Strategies Made Simple for Mutual Funds

Find out the best strategy for rebalancing your investment portfolio. Photo:

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Rebalancing an investment portfolio of mutual funds is an easy and responsible way to 'buy low and sell high.' But what does it mean to rebalance a portfolio? How often is rebalancing necessary and what are the best strategies and times to do it? In this article, we teach about the benefits and strategies of rebalancing a portfolio.

What Does it Mean to 'Rebalance' a Portfolio?

When you finally finish building your portfolio of mutual funds, you'll still need to do some maintenance on a periodic basis, even if you are a buy and hold investor. Rebalancing a portfolio of mutual funds is simply the act of returning one's current investment allocations back to the original investment allocations.

Rebalancing will require buying and/or selling shares of some or all of your mutual funds to bring the allocation percentages back into balance. In different words, rebalancing is an important maintenance aspect of building a portfolio of mutual funds, just as an oil change or tune-up is to the ongoing maintenance of your car.

The idea of rebalancing is quite simple but the timing and frequency of rebalancing can add some strategy into the process. In fact, many investors make rebalancing more complex than it needs to be. Financial planners and money managers often argue over how often an investor should rebalance. Should it be monthly, quarterly, yearly or something different? 

Rebalancing and Asset Allocation

Before thinking about rebalancing, you may want to revisit balancing. The balance of an investment portfolio consists of its asset allocation and the underlying investment types. For example, an investor may begin with an asset allocation of 80% stocks and 20% bonds. Within that allocation, the investor may have 5 mutual funds, such as 4 stock funds at 20% allocation each and one bond fund at 20%. This asset allocation or balance is one that is based upon the investor's risk tolerance and investment objective (i.e. reason for investing, time frame for investing).

Why Should You Rebalance Your Portfolio?

The reason why investors rebalance their portfolios in the first place is important to understand. Often certain mutual funds or mutual fund types will do better than others over a given period of time. For example, over the course of one year, assume that your stock funds perform extremely well but your bond funds perform poorly.

If your original allocation was 80% stocks and 20% bonds, your end-of-year allocation may now be 90% stocks and 10% bonds. You are now out of balance and this new, more aggressive allocation may expose you to unwanted risk. Conversely, if stocks do poorly and bonds do well, the next year you may be taking a lower level of risk and may miss out on gains in the stock market.

To rebalance, you simply make the appropriate trades to return your mutual funds back to their target allocations. For example, returning to our 5 fund portfolio example, you would buy and sell shares of the appropriate funds to get back to the original 20% allocation for each fund.

Naturally, you will sell shares of the funds that did best during the year to bring them back down to 20% and buy shares of the funds that did poorly so you may bring them back up to 20%. You have then successfully sold the winners and bought the losers—a sound investment strategy.

How Often Should You Rebalance Your Portfolio?

The frequency of rebalancing need not be often because it is rare that large swings in financial markets will cause your portfolio of mutual funds to dramatically change your original allocation percentages. If you allocate 20% to one particular fund, it is not often it will swing more than 3 or 4 percentage points beyond that allocation within any given year.

Also, there can be trading costs associated with buying and selling funds. So rebalancing too often can diminish the potential positive effects of doing it. Once per year is a sufficient frequency for rebalancing your mutual fund portfolio. Many people do it at the end of the year when other year-end strategies, such as tax loss harvesting, are wise to consider.

You may also choose a memorable date, such as an anniversary or a birthday. Also, before you rebalance, be sure your financial outlook and investment objectives have not changed in such a way that you need to change your asset allocation.

Bottom Line

Rebalancing a portfolio of mutual funds is typically needed just once per year. This is because the capital markets don't tend to have large swings in price in shorter time periods. Some account management tools with online brokerage accounts, mutual fund companies, or 401(k) plan websites may also offer an automatic rebalance option.

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