How to Rebalance a Portfolio

There are two easy ways to rebalance your investment portfolio.

While these methods work best for investments in diversified assets such as mutual and exchange traded funds, they can also be employed for non-diversified assets.

Perhaps your target asset allocation is 70% equities and 30% bonds, with an acceptable absolute target range of +/- 10%. After your latest portfolio review, you find that your actual asset allocation is 55% equities and 45% bonds.

You need to bring your portfolio back in line with your target allocation.

What do you do?

Divest and Reallocate the Proceeds

The obvious solution.

Sell 15% of your bond holdings and purchase equity investments with the proceeds.

Quick and simple. A big advantage.

The other potential advantage is that you are realizing profits. Perhaps an asset class (in our example, fixed income) goes on a lengthy bull market run and becomes overheated. By taking profits periodically, you can hedge against a downturn. Conversely, by reallocating to underperforming asset classes, you may achieve a boost when it begins to appreciate again.

Of course, you could be selling a great investment and moving the proceeds into a bad asset. Maybe selling Amazon and buying AIG over the last 15 years. Not a recipe for success. Which is why divest and reallocate may be better for well-diversified investments rather than individual stocks or bonds. And why reviewing non-diversified assets requires greater skill and care.

The real trouble with this method is that you usually incur costs on the rebalancing transactions.

Fund Commissions

One cost may be fund company commissions on purchases and redemptions.

If you own front or back-end load funds – do not invest in load funds unless you are convinced they are worth it in special circumstances – you may need to pay a sales fee to the mutual fund company. This can be quite onerous, especially for back-end load funds where you redeem relatively soon after acquisition.

Brokerage Fees

There may also be brokerage commissions paid.

Sometimes these are waived on no-transaction fee funds, but often there is a holding period required before you are safe. When buying no-transaction fee funds through your broker, read the fine print to see what, if any, charges you will incur on early redemptions.

Taxes Payable

The final hard cost associated with divesting and reallocating may be capital gains taxes payable.

In our example above, perhaps you initially invested USD 10,000 into equities (target 70% = USD 7000) and bonds (target 30% = USD 3000). During your review, the equities stayed flat at USD 7000 (actual 55%), but the bonds appreciated in value to USD 5800 (actual 45%).

If you sell enough bonds to revert to the target allocation of 30%, you have a profit of about USD 1064. Assuming all is capital, that capital gains are taxed at 20% (rates differ significantly between jurisdictions), and your investments are not in a tax-sheltered account, you owe the government USD 213 simply because you wanted to rebalance.

It may not sound like much, but your tax liability equates to 2% of your entire portfolio. That is an expensive fee to pay.

While divesting and reallocating may be the obvious solution, it may not be the best option outside of a tax-deferred investment account.

As an aside, always make use of tax deferred investment accounts if they are available.

Reallocate Future Acquisitions

Perhaps not as rapid a solution as divesting, but one that avoids immediate tax consequences.

If you have the investment capital on hand, you can purchase enough of the under-weighted asset to bring it back in line with the target allocation. But many investors do not have lump sums of cash on hand to invest in one transaction.

Fortunately, this method dovetails nicely for investors who utilize dollar cost averaging in accumulating assets.

In our example above, let us say that you invest USD 300 per month. Under your target allocation, you would allocate acquisitions at USD 210 to equities and USD 90 to bonds. Note though, in practice you will probably not invest exactly like this on a monthly basis. You need to adjust investing patterns based on amounts, periodicity, transaction costs, etc.

However, to bring yourself back in line with your master target allocation, you will have to alter your monthly split. You could reallocate future allocations to 100% equities until such time that your overall portfolio reverts to your target 70-30 ratio. At that point, you can go back to your original investment split.

In our example, the actual allocation shifted to USD 7000 equities (55%) and USD 5800 bonds (45%). If you allocate all USD 300 each month to equities, you could gradually get back to your target levels without triggering any tax liability. In this case, assuming that both the equities and bonds do not change in price, it would take about 24 months to reach your target allocation again.

Not the fastest method, but one that avoids taxes.

And no doubt, in 12 months at your next portfolio review, you will have to readjust the future allocations again.

Another plus is that by altering future purchase patterns until rebalanced, you buy the underperforming asset (hopefully) “on sale” and avoid a potentially overvalued asset. Again, assessing asset quality is part of the review process.

The potential drawback to this method is that you are not crystallizing profits. Yes, you are shifting future purchases to relative underperforming asset classes or subclasses. But if interest rates increase quickly, you may see your unrealized bond gains decrease or be lost entirely.

Summary

The advantage of divesting and reallocating is that it is a quick fix.

Another potential advantage is that you are realizing profits. As well as hopefully selling an overvalued asset and buying one that is “on sale”. Of course, perhaps you are selling a strong asset you should keep and shifting the profits into a dog. That is why this tends to work well with diversified investments and why proper portfolio reviews are important. But yes, always a psychological issue to sell winners and purchase perceived losers regardless of review research.

The big downside of divest and reallocate is that you may incur costs on the rebalancing, especially relating to capital gains taxation. But if your assets are held in tax efficient investment accounts, this is not really an issue.

Using future investment capital to adjust your asset allocation over time is a much slower process. How slow depends on your periodic contributions and the amount you need to adjust. While you will incur transaction costs on those future acquisitions, your total expenses relating to the readjustment will be less. Why? Because you are not disposing of profitable assets and triggering any tax liability on realized capital gains.

On the other hand, you are not locking in profits and immediately buying other “on sale” assets.

Given today’s relatively low transaction costs on buying and selling, as well as the extensive use of tax efficient investment accounts, divest and reallocate may be preferable. As well, investing in well-diversified assets reduces the risk of moving from a superior investment to a perennial cellar dweller.

However, costs can add up if you reallocate too often. So reallocating purchases over time in your normal buying periodicity may work better for you. Even when investing in a tax-deferred or tax-free account.