Rebalancing your investment portfolio simply means returning your investment assets back to their original percentages. Mitch is a 45-year-old investor with a preferred asset allocation of 60% stocks and 40% bonds. After a year of booming stock market returns, Mitch’s asset allocation drifted to 70% stocks and 30% bonds. Rebalancing will get Mitch’s investments back to his original investment percentages.

Not only will rebalancing temper any losses, there’s research that recommends annual rebalancing to boost annual investment returns up to 1% per year. Understand these rebalancing tips and your investment portfolio will likely perform better with less volatility. (For more, see: Rebalance Your Portfolio to Stay on Track.)

Keep Risk at Bay

If Mitch does nothing and the stock market has one if it’s cyclical declines, his portfolio will fall a greater amount than if he had rebalanced to his original 60:40 allocation.

Without rebalancing, at the 70% stock allocation, a 25% drop in the stock market causes his total portfolio to fall 17.5% in contrast with a 15% decline with the original 60:40 mix. If Mitch doesn’t rebalance, the 25% market decline causes a $100,000 portfolio to lose $17,500 in value in contrast with a $15,000 drop after rebalancing. That’s an additional $1,500 up in smoke for a failure to rebalance. (For more, see: Types of Rebalancing Strategies.)

Without rebalancing, your portfolio will usually become riskier. With greater drops during investment declines, you may be tempted to sell at market troughs and consequently damage your portfolio.

Diversification May Increase Investment Returns

One of the greatest benefits of a diversified portfolio is holding uncorrelated assets. Less correlated assets are those investment categories which don’t move in lockstep. For example, if the returns of international emerging market stocks go up when U.S. bonds go down, then holding both those asset classes together will reduce overall portfolio volatility. An added, well-researched finding is that these less-correlated asset classes will likely increase total portfolio returns more than holding several closely correlated assets.

So, rebalancing a diversified portfolio can increase overall returns and reduce risk. (For more, see: Diversification: Protecting Portfolios from Mass Destruction.)

Keep Investors Disciplined

No one can predict the market returns perfectly. But rebalancing may be the next best thing to a crystal ball. Back to Mitch, who after a year found his 60:40 portfolio at 70% stocks and 30% bonds. To rebalance, Mitch sells 10% of the richly valued stock funds and uses the proceeds to buy the cheaper valued bonds. In other words, rebalancing forces the investor to sell the asset classes that have yielded the greatest returns during the past year and buy the underperforming asset classes. (For more, see: Portfolio Management Pays Off in a Tough Market.)

Although rebalancing won’t guarantee buying at the absolute bottom and selling at the peak, it will allow the investor to buy lower and sell higher.

Don’t Forget Taxes

If all of your client’s investments are in a 401(k) or IRA retirement account, then you don’t need to worry about the tax consequences. If the investor sells appreciated assets outside a tax sheltered account, then individual realizes a taxable event.

To keep the tax consequences of selling appreciated assets as low as possible, have the client sell assets purchased more than a year ago. That will count as a long term capital gain, which is taxed at a lower rate than selling assets purchased within the year. Selling assets within one year triggers higher short term capital gains tax rates. (For more, see: What You Need to Know About Capital Gains and Taxes.)

How Often to Rebalance?

There’s no perfect answer to this question. Some advisors recommend quarterly rebalancing. Once per year seems to be sufficient. The client portfolio is always out of balance to some degree since as soon as it’s rebalanced, asset prices change and so will investment proportions. (For more, see: The Role of Rebalancing.)

Annual rebalancing will minimize short term capital gains and give the outperforming asset classes a full year to advance. Paul Merriman, investment authority, found that over 44 years, the exact same portfolio returned 10.3% with annual rebalancing and only 9.3% with monthly rebalancing.

When to Rebalance?

Behavioral finance experts have noticed a “stock market anomaly” which demonstrates that in January stocks tend to outperform. Again, researchers found that since stocks tend to do well in the first quarter, it’s a good idea to rebalance at the beginning of the year. This will also help the investor’s tax picture by putting off selling the best performers until the next year thus delaying the tax burden for a year. (For related reading see: Time to Rebalance? Weakness in These ETFs Says So.)

The Bottom Line

By understanding the why’s and how’s of rebalancing, the investor benefits. By holding a diversified portfolio and annually rebalancing, the investor also experiences higher overall returns than holding fewer more correlated asset classes. Finally, annual rebalancing offers the disciplined investor the probability of higher long term investment returns along with less volatility or risk. (For more, see: Portfolio Rebalancing Made Easy.)

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