Over the years, your investment portfolio may have felt perfectly balanced. However, just because it worked well in the past doesn’t mean it still suits your needs today. Whether you’ve made any changes or not, your portfolio’s composition may look quite different from what you originally planned. This could be due to some investments outperforming while others have underperformed, leading to a shift in the balance between asset classes.

If your portfolio has drifted from its original structure, it may be time to rebalance and realign it with your investment goals.

Why Rebalance?

When you first set up your portfolio, you likely decided on target percentages for different types of investments, such as stocks and bonds. For example, you might have chosen a 60% stock and 40% bond split. Over time, market fluctuations will cause these percentages to shift. Suppose the stock market experiences a significant drop of 20%, while bonds rise by 5%. After these changes, not only would the overall value of your portfolio decrease, but the stock allocation would now make up only 53% of your portfolio instead of 60%. To get back on track, you would need to invest more in stocks to bring your allocation back to the original target.

Rebalancing isn’t just about maintaining a desired portfolio mix — it’s primarily about managing your risk. Without rebalancing, a rising stock market could cause your stock exposure to grow beyond your comfort zone, leaving you vulnerable when the market eventually declines.

Rebalancing Within Asset Classes

Rebalancing isn’t limited to just shifting between stocks and bonds. You can also make adjustments within each asset class. For example, you might initially allocate 70% of your stock investments to U.S. companies and 30% to foreign companies. If U.S. stocks are underperforming, you could increase your investment in them, while trimming back on foreign stocks if they are doing particularly well. This approach helps maintain a balanced risk level and may even increase returns if it allows you to buy low and sell high.

While this strategy can improve your portfolio’s performance over time, it’s not a guaranteed success. The key is managing risk, not just aiming for high returns.

Rebalancing Challenges

Rebalancing can sound simple in theory, but it’s often tough to implement in practice. When markets are down, many investors panic and sell off their investments. However, buying when others are selling can be an effective way to enhance returns in the long run. This requires strong discipline and the ability to stick to your target allocations, even when market conditions are unfavorable.

How often should you rebalance? There’s no one-size-fits-all answer, but some investors choose to rebalance quarterly or annually. Others prefer to only rebalance when their asset allocation deviates by a certain percentage, such as when foreign stocks rise above 25% or fall below 15% of their portfolio.

The Importance of Diversification

To minimize the risk of large losses, it’s crucial to diversify your investments. Concentrating too much of your money in a single stock or sector can lead to devastating losses if that investment falters. Rebalancing within diversified investments — like mutual funds or exchange-traded funds (ETFs) — can help prevent catastrophic losses by spreading your risk across a range of assets.

While rebalancing can help manage risk, it also comes with some costs. Trading fees can reduce the benefits of rebalancing, so consider how frequently you want to make changes based on your transaction costs. Taxes are another factor to keep in mind. Rebalancing within a tax-advantaged retirement account, such as an IRA, doesn’t trigger taxes. However, selling investments in a taxable account could result in a hefty tax bill, particularly if you sell investments that have appreciated significantly. In such cases, consider rebalancing by redirecting dividends, interest, and new contributions to the underperforming asset classes, rather than selling investments with large capital gains.

Conclusion

Regularly checking in on your investment portfolio and making necessary adjustments is crucial to ensure it continues to meet your financial goals. While rebalancing may seem straightforward, it requires careful consideration and discipline. By keeping an eye on market trends, sticking to your target allocations, and being mindful of trading costs and taxes, you can maintain a well-balanced portfolio that helps you navigate both good and bad market conditions.