Personal Finance

With US stocks surging, now is the time to rebalance

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The run-up in U.S. stocks may have pushed the desired mix of assets in your portfolio out of whack. If that's the case, you may need to rebalance.

Rebalancing is an easy strategy that can cut risk. To rebalance, you sell assets that have appreciated and buy those have fallen in value. It's a counterintuitive process that forces you to buy low and sell high.

"The biggest mistake investors make with rebalancing is not doing it on a consistent basis," said Joel Cundick, a certified financial planner in McLean, Virginia. "They forget one quarter, or they look at their accounts and decide that they are not going to sell the high-performing asset class in exchange for buying an asset class that doesn't look attractive."

How rebalancing works

Let's say you have a portfolio with a target allocation of 50 percent in U.S. stocks and 50 percent in international stocks. Then U.S. stocks rise 10 percent and international stocks fall 10 percent over time.

In this scenario, you would have a portfolio of 55 percent in U.S. stocks and 45 percent in international stocks. So you'd need to sell U.S. stocks and buy international stocks to rebalance the portfolio to the allocation you originally wanted.

"The nice thing about rebalancing is that it is simple to understand and helps investors stick to their plan regardless of what the market does," said Charles Rotblut, vice president of the American Association of Individual Investors and editor of the AAII Journal.

Rotblut conducts an on-going analysis of the benefits of rebalancing. He has tracked the performance of hypothetical portfolios based on the AAII's moderate asset allocation model since 1988. The model portfolios allocate 20 percent to large-company stocks, 20 percent to midsize-company stocks, 10 percent to small-company stocks, 15 percent to international stocks, 5 percent to emerging market stocks and 30 percent to bonds.

From 1988 to 2015, the rebalanced portfolio generated an annualized return of 9.1 percent while the portfolio that wasn't rebalanced had an annualized return of 9.3 percent.

Though the returns in both portfolios were similar, the rebalanced portfolio did so with 12 percent less volatility. The rebalanced portfolio's largest annual loss was 26.9 percent versus 32.8 percent for the portfolio with no rebalancing.

"You look to rebalancing as a way to minimize risk, not maximize returns," said Colleen Jaconetti, a senior investment analyst with the Vanguard Group.

A 2015 Vanguard study by Jaconetti and two others analyzed the impact of rebalancing on the performance of several hypothetical portfolios from 1926 through 2014. Vanguard analysts concluded that "just as there is no universally optimal asset allocation, there is no universally optimal rebalancing strategy. The only clear advantage so far as maintaining a portfolio's risk-and-return characteristics is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than with a never-rebalanced portfolio."

When to rebalance

Finding your formula for rebalancing comes down to two factors: how often you rebalance your portfolio and how comfortable you are with your portfolio deviating from its target allocation.

Some investors rebalance portfolios quarterly, semi-annually or annually. Others prefer to rebalance only when a portfolio mix strays beyond a by a predetermined minimum percentage, such as 1 percent, 5 percent, 10 percent, of a target allocation.

Many investors combine those two approaches by checking their portfolios on a set schedule and rebalance only when their portfolios deviate from target allocation by a preset percentage. For example, Rotblut reviews his portfolio twice a year and rebalances if assets have gone 5 percent above or 5 percent below their target allocations.

Retirement red zone

Vanguard analysts found that a strategy that monitors a portfolio annually or semiannually and rebalances when assets move away 5 percent or more from target allocations works well for most portfolios.

"This is a nice middle ground between the time and costs of keeping the portfolio within its target allocations and the benefits of rebalancing," Jaconetti said. "Rebalancing is not always free."

Annual rebalancing may work better for taxable accounts because rebalancing can come with some costs. For example, you may have to pay capital gains taxes if an asset has appreciated in value. You also may have to pay brokerage commissions to trade stocks, bonds and exchange-traded funds to rebalance your portfolio.

Investors can get around some of the costs of rebalancing by using the portfolio cash flows to fund the rebalancing, Jaconetti said. To do this, put taxable portfolio cash from dividends, interest payments, realized capital gains or new contributions into a money market or checking account. Then use that money to buy assets to hit your target allocation.

Tools to help you rebalance

Rebalancing doesn't have to be a chore. Many retirement plans and some individual retirement account providers such as Fidelity allow investors to automatically rebalance their portfolios based on their preferences. Last year, 61 percent of retirement plans offered a automatic rebalancing feature for plan participants, according to benefits consulting firm Aon Hewitt.

Automated investing services, such as Betterment, FutureAdvisor and Wealthfront as well as those offered by Charles Schwab and Vanguard, will automatically rebalance your portfolio. And regular portfolio rebalancing is a core service provided by most financial advisors.

Do-it-yourselfers need not despair. The AAII's Rotblut uses a spreadsheet to calculate when he needs to rebalance his portfolio. Mutual fund research company Morningstar provides a free Instant X-Ray tool to evaluate the asset allocation of your portfolio that can help you determine when you need to rebalance.

With a rebalanced portfolio, you are better prepared for when volatility strikes again.

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