Investment portfolios should be rebalanced regularly, though there are special considerations.
It is important to clarify with clients the difference between rebalancing and reallocating, says Kevin Meehan, a CFP and regional president of Wealth Enhancement Group in Itasca, Ill.
Reallocating is shifting the base ratio of different investments, and clients shouldn’t do that unless their goals and/or risk tolerance have shifted. Rebalancing is selling assets that have performed well and buying assets that have performed poorly.
“It helps you lock in gains and buy securities at a discount, thereby helping enhance returns over time, and it helps you stay in alignment with your desired allocation,” Meehan says.
Rebalancing can seem counterintuitive because one is selling those assets that have done well while buying more of the investments that haven’t performed as well, says Robert Pagliarini, a planner and author of “The Sudden Wealth Solution: 12 Principles to Transform Sudden Wealth into Lasting Wealth” (Harbinger Press, 2015).
“I am less of a fan of rebalancing based on a set time and instead prefer to rebalance if and when the allocation deviates from the target by more than a certain percentage,” says Pagliarini, a CFP who is also president of Pacifica Wealth Advisors in Mission Viejo, Calif.
Retirement accounts typically benefit from annual rebalancing, and some plans offer automatic rebalancing to a specific desired model portfolio to keep the investor disciplined, says Catherine Seeber, a CFP and a partner and senior adviser at Wescott Financial Advisory Group in Philadelphia.
However, less frequent rebalancing is recommended for taxable accounts, she says.
Clients need to determine the gain and/or loss in the position before resetting to target, and they also need to consider the timing of the capital gain distributions of the fund managers, if applicable.
“Buying a fund two days before it’s ex-dividend date will cause the investor to have to absorb the capital gain distribution as if she/he had held the fund the entire year,” Seeber says.
Rebalancing might also be warranted after large withdrawals or during extreme market volatility, she says.
Even though it may seem like a bad strategy to lighten up on the winners in a portfolio, it is often those same stocks and sectors that fall out of favor and begin to underperform when market sentiment changes, says Claudia Mott, a CFP and the principal of Epona Financial Solutions in Basking Ridge, N.J.
“When market shifts occur, the undervalued investments that have lagged often become the performance leaders,” she says. “The process of rebalancing reduces the portfolio’s exposure to potentially overvalued investments whose risk profile may no longer meet those of the investor.”
Katie Kuehner-Hebert is a freelance writer in Running Springs, Calif. She has contributed to American Banker, Risk & Insurance and Human Resource Executive.
This story is part of a 30-30 series on ways to build a better portfolio.