All About Rebalancing

Financial planning includes financial education. We believe that, for optimal investment results, an investor should commit to a chosen portfolio allocation. We refer to this allocation as a “well diversified, balanced portfolio”. Rebalancing is the process of bringing your portfolio back to the original asset allocations you have set for it.

As part of our education process, we discuss rebalancing with clients. Typically, the initial conversation goes like this:

Me: We typically rebalance your portfolio once annually. Do you know what it means to rebalance?

Client: Oh, yes!

Me: Great – let’s compare notes. How would you do it?

Client: Uhhh, maybe you’d better tell me what you’re talking about.

I’m not trying to embarrass anybody here, certainly not a client. The purpose of this exercise is to jolt the thought process away from mental skimming: just because you’ve heard a word ad nauseum and kind of have an idea of what it might mean doesn’t translate to the necessary comprehension of how it will impact you. (Another purpose is to skip a step if they really do have a thorough understanding of rebalancing).

For example, here is the recommended asset allocation we use for client portfolios:

Category                                                                            %

Large Cap Growth                                                            17

Large Cap Value                                                                17

Small Cap Growth                                                            17

Small Cap Value                                                                17

Large Diversified International                                      10

Emerging Markets                                                            10

Real Estate                                                                          10

Cash                                                                                        2

Total                                                                                   100%


You’ll notice that there are no specific mutual funds and ETF’s listed, just the asset categories. That is because the actual funds we recommend change from time-to-time, for a variety of reason, but the categories remain fixed.

When we first begin advising on a client portfolio, we typically liquidate the full portfolio and invest the proceeds per the above allocation. Of course, with brokerage accounts*, tax implications must be taken into account so we may stretch the rebalancing over a couple of years to reduce taxes if the tax projection shows a significant benefit.

If you own a lot of physical properties, you also may want to forgo the Real Estate component. And some people prefer to keep zero cash. But the goal is that you own the best possible portfolio for long-term growth.

As you can imagine, the day after you put this “ideal portfolio in place”, the allocations will change. Over a year, they will likely change significantly. By “rebalancing” you are selling enough of the categories that have increased to bring the percentage back to equilibrium. For example, if Small Cap Growth stocks had a strong year and now occupy 24% of a portfolio valued at $2M, you would sell $140k to get back to $340,000 (17% of $2M).

What do you do with that $140k? You will buy funds that have decreased in value. For a simple example, let’s say that Emerging Markets had decreased to 3% of the portfolio, or $60k, and everything else has remained stable. You would use that $140k to purchase EM to bring it up to 10%, or $200k.

But doesn’t that mean you are betting on losers and selling your winners? That is what your emotional brain is telling you, isn’t it? However, markets return to equilibrium over time. There are no losers in a well-diversified equity fund portfolio held for the long term. Looked at another way, rebalancing forces you to buy low and sell high. Isn’t that the goal of every investor?

*I recently wrote about a couple who would owe around $60k in taxes from rebalancing their brokerage account, which was 100% individual stocks. The dilemma we faced was whether the loss in future growth was offset by the cost of rebalancing. Read here about the solution they chose, saving them at least $250k in taxes.

I realize this column may be pretty basic for some of our readers, but past experience has demonstrated that a solid grasp of the fundamentals is what many investors lack. In this month’s vlog, Michelle demonstrates an actual rebalance of a client portfolio based on market activity over the past year. Let me know if you have any questions after watching it.

Do you rebalance? How often? Do you have any tips for others? Please comment below!


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