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Rebalancing Your Portfolio - How, When, and Why It Matters

November 7, 2022
5 min

What is Rebalancing?

The concept isn’t difficult to understand. 

Portfolio rebalancing is the process of returning the values of a portfolio’s asset allocation to its base levels, as defined by the investment plan.

Before you put money in the market, any financial consultant would advise you to develop a strategy outlining your risk tolerance and expected returns. 

The average investor will usually have their investments in one of two asset classes: stocks or bonds. Of course, someone more experienced might explore other investment options. Still, a generally accepted principle for the everyday person is maintaining a percentage of stocks equal to 100 minus one’s age and having the rest allocated to bonds.

The logic for this ratio is that the older you get, the more critical wealth protection is. The stock market is highly volatile, while bonds are perceived as safe. A more senior investor should then opt for bonds, while a younger investor should aim to capitalize on compounding gains through the stock market.

The portfolio mix describes how you allocate your funds between investment classes, and rebalancing is how you ensure that you follow through on your investment plan despite the volatility of the markets. 

It’s the process of accounting for your investments, then redistributing the sum to realign the percentages back to your desired levels.

The Importance of Rebalancing Your Portfolio

Handling your portfolio exposure is a balancing act between the market’s volatility, risk management, and your rational mind. 

Market volatility is encapsulated in the everyday change of valuations Over time, the value of the assets included in your initial allocation will change. With that change comes unnecessary exposure to risk and changes in your expected return rate. These dangers all stem from negligent portfolio management, which exposes the stockholder to greater losses or failure to capture market gains.

A smart investor, then, is someone who assesses the current situation, breaks down future probabilities, and takes advantage of market conditions to either grow their wealth or maintain it. 

In the next section, we discuss the disadvantages of an unbalanced portfolio.

The Danger of Not Rebalancing

What happens if you don’t actively rebalance a portfolio?

Hot Hand Fallacy

If you started investing in crypto in 2013, then you likely experienced a years long bull market run – nothing like the choppy waters that we’ve been treading through over the past two years.

That said, the bull run throughout the past decade might have left you with an ill-conceived notion of the market: the Hot Hand Fallacy.

The Hot Hand Fallacy describes the human tendency to believe that a successful streak will lead to further success. It’s a common phenomenon in basketball where if a player has made five consecutive three-pointers, you might assume he’s more likely to hit the sixth than not. It’s the assumption that whatever is happening now will continue to occur in the future. Behavioral scientists found this concept to result from several psychologic factors, including confirmation bias, the illusion of control, overconfidence, and recency bias.

While using historical data to inform future investment decisions is the basis for technical analysis, assuming that a bull run will continue without adequately analyzing the current environment is a recipe for disaster. 

Remember, the markets are cyclical, and rallies always come to an end. Portfolio rebalancing is a way to take a little off the upside and hedge your bets to protect whatever gains you made.

More risks than you're willing to take

Failure to rebalance a portfolio opens you up to excessive volatility. Admittedly, short-term fluctuations do happen. They’re a natural part of the stock market and shouldn’t raise any mental alarms. However, if your risk tolerance can’t stand it, excessive volatility may make you reconsider some choices.

If you have a good portfolio strategy and a long-term horizon, you wouldn’t usually have to worry about this. Just know a good portfolio strategy involves some level of quarterly auditing and portfolio rebalancing as well.

How To Rebalance Your Portfolio

Because each investor has different goals depending on their investment strategy, the allocation models for every investor will differ. There’s no right or wrong model, so the first thing you should look to establish is: “What are the elements of a balanced portfolio for you?” The elements required to build your vision of a balanced portfolio include risk tolerance, growth expectations, and investment time horizons. 

Once you’ve established your ideal vision of a balanced portfolio, here’s how you could get to rebalancing it.

Calendar Rebalancing

Often described as the most basic rebalancing approach; this strategy analyzes investments at specific times throughout the year. 

Calendar Rebalancing involves accounting for the weights of each asset class in proportion to the total fund value. If you have a total of $10,000 invested, then owning bonds worth $5,500 means 55% of your investments are in bonds, with the remaining 45% allocated to stocks. If the asset allocation was targeted at a 50-50 split, you take out the $500 and add it into stocks.

Smart Beta Rebalancing

Smart Beta Rebalancing is a tad bit trickier.

The overall goal of smart beta is to obtain alpha, which is lowered risk or increased diversification at a cost lower than actively managed funds. In short, it seeks to provide the best construction of an optimal portfolio by accounting for value, momentum, quality, size, and volatility factors.

Whereas Calendar Rebalancing means adjusting the weights of your assets according to predetermined levels, Smart Beta Rebalancing allows you to adjust the weights themselves. A 50-50 split between bonds and stocks could be adjusted to 40-60 or even 70-30, depending on market conditions. 

This adds a layer of systematic analysis that Calendar Rebalancing simply lacks. Smart Beta Rebalancing is much more difficult, however, and can open you up to take on more risk and volatility than you would have otherwise wanted.

Constant-Mix Rebalancing

It’s difficult to maintain specific values in the constant flux of the stock market. The Constant Mix Rebalancing method accounts for this as it assigns specific tolerance levels for each asset class to rubber band in.

Going back to our 50-50 example, a tolerance level of +-10% means that the portfolio will only have to be rebalanced once either stocks or bonds fall under or over 40-60% of the portfolio’s value.

When to Rebalance Your Portfolio

Goals and market fluctuations an rapidly change your portfolio’s asset allocation, so it’s important to monitor your portfolio on a regular basis and make adjustments when needed.

Excessive Market Volatility

Your portfolio should always reflect your goals, risk tolerance, and the market’s current conditions. Excessive market volatility is one such factor.

In cases of high market fluctuation, portfolio rebalancing becomes a necessity to match desired performance, whether that’s wealth protection or wealth generation.

Diversification Purposes

Rebalancing reduces risk and potentially increase long-term returns. 

Without rebalancing, a portfolio tends to become more concentrated in the assets that have performed well. As we had discussed in the Hot Hand Fallacy, this can't last forever, so it’s only a matter of time before the markets bring these valuations back down to earth.

In the redistribution of wealth, diversification is also accomplished.

Life Events

Your portfolio’s expected returns are dictated not only by personal factors and goals but also by the moment in which one lives. An 18-year-old would generally focus on wealth generation with a stock-bond allocation of 70-30, while a senior nearing retirement might want to focus on wealth preservation with an asset allocation of 30-70 in favor of bonds. Your asset mix is affected by your timeline goals as well.

Does Rebalancing Have Costs?

Like anything in life, rebalancing also comes with its own costs. Taxes greatly impact profitability as short-term capital gains (gains made from selling stock held for one year or less) are taxed at regular income rates, whereas long-term capital gains are taxed at no more than a flat rate of 15%-20% with few exceptions.

How To Avoid Taxes When Rebalancing Investments

That said, there are ways to minimize your tax contributions.

1. Using Tax-Advantaged Accounts

If you do your rebalancing in a tax-deferred account, like a 401(k) or a Roth IRA, you’d steer clear of any tax whatsoever. As these retirement accounts are subject to special rules, you won’t have to pay tax, if any, until the money is withdrawn in retirement. 

2. New Contributions

Instead of selling already invested money, an investor can inject new money into the portfolio to avoid tax consequences. While it may be difficult to acquire excess cash, this is still the simplest way to avoid tax problems. 

3. Capital Losses Offset Gains

Also known as tax-loss harvesting. If you use a taxable account, you can file for net zero gains if, for example, you made a winning investment of $2,000 and realized a capital loss of $2,000 in another trade.

Automatic Rebalancing With Peccala

Rebalancing your portfolio will help you stick to your investment plan regardless of market conditions, but it can also be a tough, arduous, and expensive process when done wrong. 

Peccala simplifies this process by handling everything for you. Peccala’s strategies all help you establish an acceptable degree of tolerance from the outset, limiting the need to rebalance your portfolio. Once you’ve invested with Peccala, the trading engine continuously recalculates assets and derivatives every hour, removing the need for constant management and asset calculation.

This process also comes at no extra cost since you don’t directly hold the assets you’re investing in, removing the need to pay taxes on each trade.

Worry less and live your life more by investing with Peccala.

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