Rebalancing your portfolio

Rebalancing refers to making adjustments to your portfolio when your preferred asset allocation has shifted and is an important tool to keep you from straying too far from that asset mix.

There are many reasons to make changes to your original investment plan. If something has changed with your overall goals or with your life circumstances, you should check your asset mix and see if it still works for you.

As you get closer to your goal, your investment time horizon gets shorter. An asset mix that worked for a goal originally 20 years away might not be appropriate when your goal is now only 5 years away.

The amount you want to save may change, too, if you decide you need less or more than expected. You might also discover that your risk tolerance isn't what you thought it was. If you see your balance drop when you have plenty of time to reach your goal, you may not worry as much since you have a chance for it to recover. But if you see market volatility closer to retirement, it can be unsettling.

In addition to changes in your circumstances, market fluctuations may cause your asset allocation to move outside your comfort zone. Your portfolio's risk level may change even if you don't make any modifications to your investments. As the underlying value of your funds fluctuates, your allocation may begin to drift away from your target mix. As a result, you may find that you're over- or underweighted in stocks, exposing you to more or less risk than you're comfortable with.

Let's say you have a portfolio of 70% stocks and 30% bonds, and you've decided to rebalance when your allocation is off-target by 5 percentage points or more.

During your periodic review, you notice your portfolio has drifted to 76% stocks and 24% bonds. It's now time to make some adjustments to stay on track with your risk and return objectives. You have 2 options:

1. Rebalance your portfolio back to the 70/30 mix.
2. Set a new target if your goals or circumstances have changed and caused you to become more or less tolerant of risk. 

Our experts examined methods commonly used by investors, advisors, and asset managers for rebalancing portfolios:

This type of rebalancing designates a frequency for resetting the portfolio back to the target asset allocation. You can use this method to conduct a review on a quarterly or yearly basis.

This is triggered when a portfolio experiences a change in its asset allocation that exceeds a certain threshold. One major drawback of threshold-based rebalancing is that it requires regular monitoring and may not be practical for you if you manage your own portfolio. You can use this method to conduct reviews on a daily basis.

This type of rebalancing combines both approaches. Based on a calendar frequency, your portfolio is rebalanced if its assets have strayed by more than a specific percentage from the target allocation. You can use this method to combine a calendar review with an asset drift readjustment.

Whichever method you choose, make a plan to review your portfolio, comparing your current asset allocation against your desired asset allocation, noting the progress toward your goals, and buying or selling investments to reach your preferred asset mix.

Our research has shown that optimal rebalancing methods are neither too frequent, such as monthly or quarterly calendar-based methods, nor too infrequent, such as rebalancing only every 2 years. For many investors, implementing an annual rebalance is optimal. However, if this doesn't work with your schedule, don't stress about the specifics. The important thing is to pick a schedule that's easy to follow, so set a reminder on your calendar and stick with it.

If you're 73 or older, take your required minimum distribution (RMD) from your retirement account(s) while you're rebalancing your portfolio. You can then reinvest your RMDs in one of your taxable accounts with an underweighted asset class.

When it's time to rebalance your portfolio, consider these tax-efficient best practices to potentially improve your investment performance without sacrificing your risk/return profile:

To minimize transaction costs and taxes, you could opt to partially rebalance your portfolio to its target asset allocation. Focusing primarily on shares with a higher cost basis (in taxable accounts) or on asset classes that are extremely overweighted or underweighted will limit both taxes and transaction costs associated with rebalancing.  

Instead of buying or selling investments to rebalance, move dividends and interest to your portfolio's underweighted asset classes. When you withdraw money from your portfolio, start with your overweighted asset classes. 

Every investor's goal is to buy low and sell high. But the purpose of rebalancing is to manage risk, not maximize returns. Rebalancing isn't about market-timing; it's about sticking to Vanguard's principles for investing success and creating a strategy to stay in sync with your long-term goals.