Rebalancing your investment portfolio is a time-tested method to help dampen volatility and improve long-term returns. However, rebalancing without a plan can be more damaging than helpful. There are times when you should definitely rebalance your portfolio, and other times when you might be better served by waiting. Given the current state of the economy and the financial markets, now might be one of those times when you should consider rebalancing. Here’s a look at the reasons why.
Rebalancing According To a Calendar Isn’t Ideal
Traditionally, investors have been told that the best time to rebalance a portfolio is annually, often at the end of the year. While rebalancing, in general, is to be encouraged, arbitrarily assigning a calendar date to when you should rebalance is inefficient at best. Rebalancing is only necessary when a portfolio is no longer in line with its stated investment objectives and risk tolerance. In other words, rebalancing every year on Dec. 31 isn’t necessary if the portfolio is still balanced. Rebalancing can also involve costs, in the form of either commissions or tax consequences, so it should only be undertaken when appropriate.
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Your Stocks May Be Overextended
It might seem like a random time to be rebalancing a portfolio, but depending on the state of your investments, it might be warranted. After getting absolutely decimated in February and March 2020, the stock market has been on a tear, bouncing back hard from its 2020 lows and going almost straight up ever since. It’s entirely possible that some of the stocks in your portfolio, or your stock allocation in general, have tremendously outperformed your other investments, leaving your portfolio out of whack. As October is typically one of the worst months for stocks, it might be a good time to trim some of your outsized positions.
Your Stocks May Be Overconcentrated
In many cases, stocks rise in groups, not just by themselves. For example, if Apple and Facebook are rising sharply, stocks like Microsoft and Google are likely not far behind. Whether it be tech stocks or energy stocks, healthcare stocks or utilities, stocks in a winning sector tend to move in a group. If most of your stocks are in a particular industry, your portfolio might very well be overweighted not just in terms of individual stocks, but in terms of a specific sector. In this case, while you might keep your overall percentage of stocks the same, you might consider reallocating the sectors within your portfolio.
You Might Need To Protect Against Rising Interest Rates
The Fed has held interest rates artificially low throughout 2020 and 2021 in an effort to save the economy from falling into a deep recession triggered by the coronavirus pandemic. However, now that vaccinations are widespread and the economy is reopening, it’s inevitable that the Fed raises rates again at some point. That might not happen in 2021 or even 2022, but market interest rates are likely to trend up in anticipation of inflation-fighting moves from the Fed. If your portfolio is overweighted with stocks or bonds that benefit from falling rates, it might be a good time to rebalance your positions.
Evaluate the Costs vs. the Benefits
Every time you rebalance, your portfolio may be susceptible to various costs. In addition to the commissions and taxes you might have to pay, you’re introducing the risk of opportunity cost into your portfolio. For example, if you trim some of the winners in your portfolio to reallocate that money to your losing positions, you’re reducing your exposure to the potential upside of those winners. A position that has grown from 5% to 8% of your portfolio, for example, might just be starting a big run.
Over-rebalancing can act as a drag on your profits if it continually means reducing your positions in stocks that have momentum and are moving higher. But the opposite is also true. If you own a stock that has skyrocketed and now consumes 50% of your portfolio, that position clearly needs reallocation. And in the current market environment, you might indeed find that some of your positions are out of whack. In that case, the benefits of reallocation clearly outweigh the risks and costs.
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Last updated: Sept. 29, 2021