|401(k)||VTSMX||Vanguard Total Stock Market Index Fund||$9,998||–||$2||$10,000|
|VBMFX||Vanguard Total Bond Market Index Fund||–||$9,895||$15||$10,000*|
|Roth IRA||IVV||iShares Core S&P 500 Index ETF||$5,984||–||$16||$6,000|
|GOVT||iShares U.S. Treasury Bond ETF||–||$1,989||$11||$2,000|
*0.89% of VBMFX’s asset allocation is listed as « not classified. »
Thanks to MoneyUnder30.com for the basic format of this spreadsheet.
You can break down the stock and bond categories further for a more detailed picture. What percentage of your stocks, for example, are small-cap or large-cap? What percentage are domestic or international? What percentage of your bonds are corporate and what percentage are government-issued securities?
You’ll notice when you look up your funds’ asset allocations that funds supposedly 100% dedicated to a specific asset class often have a tiny percentage of their holdings, perhaps 0.5% to 2%, in cash. Don’t sweat this small detail when rebalancing your portfolio.
Also, in the example above, you’ll note that our investor hasn’t strayed far from their target asset allocation. They might decide not to bother rebalancing until the difference is 5% or even 10%.
2. Brokerage software
Some brokerage firms allow their customers to view all their investments in one place, not just the investments they hold with that brokerage. Examples include the Merrill Edge Asset Allocator and Fidelity’s Full View.
You’ll need to provide your login information for each account whose details you want to view. If you’re using Fidelity’s Full View, for example, and you have a self-employed 401(k) with Fidelity and a Roth IRA with Vanguard, you’ll need to give Fidelity your Vanguard login details so you can see your two accounts’ combined asset allocation.
Apps such as Personal Capital’s Investment Checkup, SigFig’s Portfolio Tracker, FutureAdvisor, and Wealthica (for Canadian investors) can sync with your existing accounts to provide a regularly-updated and complete picture of your investments. You can use these apps for free; their providers are hoping you’ll sign up for one of the company’s paid services, such as portfolio management. Again, you’ll have to provide these sites with the login details of your brokerage accounts to see your combined asset allocation.
If you think finding a way to examine your overall portfolio is too much work or if you don’t want to share your login details across sites, here’s another strategy: Strive to maintain your target asset allocation in each of your accounts. Make sure your 401(k) is allocated the right percentage to stocks and to bonds, and do the same for your IRA. Then rebalance within each account as needed.
Analyze Your Portfolio
Once you have a complete view of your portfolio holdings, examine these four things:
1. Overall asset allocation
What percentage of your investments are in stocks, bonds, and cash and how does this allocation compare to your target allocation?
If you own shares of Berkshire Hathaway, pay careful attention. While it’s technically a stock, it has large cash and bond holdings. You might have to do some manual asset allocation calculations if the software you’re using isn’t smart enough to recognize this.
2. Overall risk
If you find that you have 70% stocks and 30% bonds, is that too risky for you? If you find that you have 20% cash, 30% bonds, and 50% stocks, are you not taking enough risk to meet your investment goals?
3. Overall fees
Ideally, you want your investment fees to be as close to zero as possible, and thanks to increased innovation and competition in the investment marketplace you might be able to achieve this goal. Fidelity Total Market Index Fund (FSKAX), for example, has an annual expense ratio of 0.015%.
The higher your investment fees, the lower your returns, all else being equal. Other fees to watch out for include loads for buying and selling mutual funds and commissions for buying and selling stocks and exchange-traded funds (ETFs). For long-term buy-and-hold investors, loads and commissions may cost less over time than annual expense ratios.
Are your portfolio’s returns meeting your goals? If they aren’t, that’s not necessarily a problem: What you really care about are the long-term average annual returns. That’s why you want to look at how your portfolio’s investments are performing compared to similar investments.
Is your stock market fund tracking the index it’s supposed to track? You can look this up on Morningstar, which has determined appropriate benchmarks for different funds and has created color-coded graphs to show you how your fund has performed against its benchmark.
Another possibility is that your portfolio’s asset allocation can’t possibly meet your goals. If your goal is to earn an 8% average annual return and your portfolio consists of 80% bonds and 20% stocks, there’s almost no chance you’re going to meet your goal unless you flip your asset allocation to 80% stocks and 20% bonds.
If at this stage, you find that you have an unwieldy number of accounts—perhaps you have several 401(k) plans with several former employers—consider consolidating them. You can roll over old 401(k) balances to an IRA (traditional or Roth, depending on which kind of 401(k) you have or whether you’re willing to pay taxes to switch to a Roth). The IRA switch will give you maximum control over your fees and investments. Or, if you like your current employer’s 401(k) and your current employer allows it, you can roll your old 401(k) balances into your current 401(k). Note that 401(k) balances have more protection against creditors.
Learn What’s New
Investment innovation might mean that what you currently hold isn’t the best option for meeting your goals. As an example, you might have an index mutual fund that charges an expense ratio of 0.5% when you could be holding a nearly identical index ETF with an expense ratio of 0.05%.
Does this sound too good to be true? How could you get a nearly identical investment for so much less? Unlike some mutual funds, ETFs rarely charge sales loads or 12b-1 (marketing) fees. Also, ETFs are usually passively managed (they follow a given index by investing in all the stocks in that index), not actively managed by human fund managers picking winners and losers. Passive management is not only less expensive but tends to yield better returns—partly due to the lower fees.
Another possibility is to move your assets to a robo-advisor, which can help lower your fees and eliminate the task of managing your own investments. We talk more about robo-advisors a bit later in this article.
What Should You Sell vs. Buy?
Next, it’s time to figure out which investments to unload from your portfolio. Primarily, you want to sell overweighted assets. If stocks have been outperforming bonds, then your desired asset allocation will have gotten out of whack in favor of stocks. You might be holding 75% stocks and 25% bonds when your goal is to hold 70% stocks and 30% bonds. In that case, you’ll need to sell 5% of your stock holdings.
Which stocks, including stock mutual funds and stock ETFs, should you sell? Start with these:
- stock funds with fees that are too high
- stock funds you don’t understand
- stocks of companies whose business model you don’t understand
- stocks and funds that are too risky or not risky enough for your tolerance
- stocks and funds that haven’t performed as well as their benchmarks or as well as you expected them to
- individual stocks that are overvalued or underperforming their peers or that no longer have a positive outlook
If it is bonds you’re looking to sell, consider these criteria:
- bonds whose credit rating has dropped (these bonds are now riskier than they were when you purchased them)
- bonds that are underperforming their benchmarks
- bonds with returns that aren’t keeping pace with inflation
- bond funds with fees that are higher than they need to be (that is, you could get a nearly identical bond fund for less)
If none of these traits apply to your holdings, sell the investment with the lowest trading fee, such as shares of a no-transaction-fee mutual fund or ETF.
Before you can purchase new investments, you’ll have to wait for your sales to settle. Settlement times, the time it takes for your sale to finalize and your cash proceeds to appear in your account, vary, depending on the type of investment bought or sold.
Most traditional security transactions settle in two business days, which in industry jargon is described as T+2—T is the date you place the trade and the 2 represents two business days. Keep in mind that if you place a trade after the market closes, it won’t be executed until the following business day.
While your sales are settling, decide what you want to buy. The easiest approach is to buy more of what you already have that you’re underweight in. Reexamine that investment and ask yourself, “Would I buy it today?” If not, seek out a new investment that aligns with your goals.
Portfolio Rebalancing by Age/Goals
Portfolio rebalancing in and of itself isn’t really a function of how old you are or what you’re trying to achieve with your portfolio. But since choosing an asset allocation is the precursor to portfolio rebalancing, let’s talk about how you might allocate your portfolio at different key times in your life.
You’ve probably read that young investors should place a high percentage of their money in stocks since they have a long time horizon and since stocks tend to perform the best in the long run. But your ideal asset allocation depends not just on your age but also on your risk tolerance. If a 10% drop in the stock market would cause you to panic and start selling stocks, you have a lower risk tolerance than someone who would see that same market drop as a buying opportunity.
This short Vanguard risk tolerance quiz can help you evaluate your risk tolerance and get an idea of how to allocate your portfolio. A simplistic formula like 100 minus your age to get the percentage of your portfolio to allocate to stocks (75% for a 25-year-old) might be a useful starting point, but you’ll need to tweak that percentage to suit your investing personality. You can invest 100% in stocks if you have a very high risk tolerance and long time horizon, for example.
That Vanguard study we were talking about earlier found that with a hypothetical portfolio invested from 1926 through 2018, average annualized returns would be as low as 5.4% for someone invested 100% in bonds and as high as 9.5% for someone invested 100% in stocks. But the difference between investing 100% in stocks versus 80% in stocks and 20% in bonds was just a percentage point, with the latter earning average annualized returns of 8.7%. Meanwhile, someone who invested 70% in stocks and 30% in bonds would have earned 8.2%, while a 60/40 investor would have earned 7.8%.
What we can take away from these findings is the importance of investing in something tried and true; maybe don’t invest 100% or even 20% of your portfolio in bitcoin, which is still considered highly speculative.
Since most people are more upset when they lose money in the stock market than they are happy when they make money in the stock market, a strategy that makes you comfortable with the amount of risk you’re taking and helps you stay the course during market corrections is the best strategy for you. So, if you’re 25 years old and keep hearing that you should be invested 80% in stocks, you don’t necessarily need to follow that advice. If you’re only comfortable with 50% in stocks and want to keep the other 50% in bonds, that’s fine.
At this point in your life, you might have received an inheritance from a parent or grandparent and be wondering what to do with the money and how the windfall should affect your investment strategy. Another scenario many people face around age 45 is needing money to send a child to college—tens of thousands of dollars, or maybe even hundreds of thousands, if you have multiple children or a private school-bound child who didn’t receive any financial aid.
If you inherit assets, such as stocks, you have to decide how they fit into your overall portfolio and rebalance accordingly. Having more money might mean you’d prefer a more conservative allocation since you don’t need to take on as much risk to achieve the growth you need.
Inheriting lots of stocks might throw your target allocation way out of whack; you might need to sell off a lot of them and buy bonds. Or you might have inherited lots of bonds and want to own more stocks. You’ll also want to think about whether the particular assets you’ve inherited are things you would buy if you were picking out investments with your own money. And if you inherit cash, well, you can just use the money to purchase the stocks and bonds you want to create your ideal asset allocation.
As far as paying for college, let’s say you have a 529 plan, a tax-advantaged account that helps families save money for education expenses. When your child is 10 or more years away from college, you can use an aggressive asset allocation with a high percentage of stocks. As your child gets closer to college-age, you need to rebalance in a way that makes your asset allocation more conservative. Use account contributions to buy bonds instead of stocks. The account’s value needs to become less volatile and more stable over time so you’ll be able to withdraw money for your child’s education when you need it without having to sell investments at a loss. Some 529 plans even have age-based options that act like target-date retirement funds but with the shorter time horizon associated with raising kids and sending them to college.
Also at age 45, if you’ve been highly successful and watched your spending carefully, you might be on track to retire early. If that’s the case, you might need to start rebalancing toward a more conservative asset allocation. Then again, you might not want to—it depends on your philosophy about stock ownership during retirement, which again has to do with your risk tolerance.
When you’re zero to 10 years away from retirement, your portfolio is considered to be in the transition stage. Most experts say you should be moving toward an asset allocation that’s weighted more heavily toward bonds than toward stocks—but not too heavily, because you still need continued growth so you won’t outlive your portfolio. Instead of moving toward the 40% bond, 60% stock asset allocation that might be recommended for someone planning to retire at age 65, you might move toward a 50/50 allocation. When rebalancing, you’ll be selling stocks and buying bonds.
Age 65 represents the early years of retirement, at least for those people able to afford to stop working. The full Social Security retirement age for people retiring right now is 66; Medicare starts at 65. In any case, at this juncture in life, give or take a few years, you’ll be thinking about withdrawing retirement account assets for income.
Rebalancing your portfolio at this age could mean selling stocks to gradually move your portfolio toward a heavier bond weighting as you get older. The only catch is that you won’t want to sell stocks at a loss; which investments you’ll sell for income will depend on what you can sell for a profit. Being diversified within each major asset class (for example, holding both large-cap and small-cap stock funds, both international and domestic stock funds, and both government and corporate bonds) gives you a better chance of always having assets to sell at a profit.
You should also have a retirement drawdown strategy in place. Perhaps you’re going to withdraw 4% of your portfolio balance in year one and adjust that dollar amount by the inflation rate in each following year. Portfolio rebalancing will require a different approach because you’re now accounting for regular withdrawals, whereas before retirement you were accounting only (or mostly) for contributions. You might also be making withdrawals from multiple accounts, which might mean rebalancing multiple accounts. Once you reach age 72, you will have to start taking required minimum distributions (RMDs) from 401(k)s and traditional IRAs to avoid tax penalties.
When you take RMDs, you can rebalance your portfolio by selling an overweight asset class. Keep in mind that you’ll be paying taxes on withdrawals of earnings and pre-tax contributions unless it’s a Roth account. People with significant assets outside of retirement accounts can rebalance in a low-cost, tax-efficient way by gifting appreciated investments to charity or gifting low-basis shares (stock shares with huge capital gains on their original value) to friends or family.
Now that you understand how the rebalancing process works, the next question is whether to do it yourself, use a robo-advisor, or use a real, live investment advisor to help you. Consider the pros and cons of each in terms of skill, time, and cost.
DIY Portfolio Rebalancing
Rebalancing your portfolio on your own, without the help of a robo-advisor or investment advisor, doesn’t require you to spend any money. What it does cost you is time; how much time depends on the complexity of your investments and your grasp of how to rebalance. If you have one IRA with one stock ETF and one bond ETF, rebalancing will be quick and easy. The more accounts and the more funds you have, the more complicated the task becomes.
The most common rebalancing advice is to sell the investments you’re overweight in (which will almost always be stocks, since they grow faster than bonds, as we mentioned earlier) and use that money to buy the investments you’re underweight in, which will almost always be bonds. But a simpler method that may have lower transaction costs is to use any new contributions to your account to purchase the investments you need more of.
If you receive a year-end bonus, a tax refund, or a large gift, use that money. If you make a lump-sum contribution to your IRA, divvy that money up between stocks and bonds in a way that rebalances your portfolio. You might not end up perfectly reallocating your investments back to your target ratio, but you might get close enough to avoid incurring any transaction costs from selling. That being said, many brokerage firms offer no-transaction-fee mutual funds and ETFs, in which case it won’t cost you anything to buy and sell exactly what you need.
The biggest risks to DIY portfolio rebalancing are not doing it at all and, if you’re working with a taxable account, incurring taxes—especially short-term capital gains taxes, which have a higher rate than long-term capital gains taxes. Any time you pay investment taxes, you’re hurting your net returns.
To sum up, here’s an example of how this whole process plays out.
Allocation before rebalancing:
- Stock mutual fund value: $7,500 (75% of your portfolio)
- Bond mutual fund value: $2,500 (25% of your portfolio)
- Sell: $500 of the stock mutual fund
- Buy: $500 of the bond mutual fund
Allocation after rebalancing:
- Stock mutual fund value: $7,000 (70% of your portfolio)
- Bond mutual fund value: $3,000 (30% of your portfolio)
One thing that might complicate this process is if the bond mutual fund you want to purchase additional shares of has a minimum investment that’s higher than $500. If that happens, you could purchase shares of a nearly identical bond ETF that doesn’t have any investment minimum.
Also, if you have to pay any commissions to buy or sell, your total ending portfolio value will dip below $10,000.
Automatic Portfolio Rebalancing
The easiest way to rebalance your DIY portfolio is to choose funds whose managers do the rebalancing for you. Target-date funds, which are mutual funds that hold a basket of investments and have an asset allocation that’s based on your projected (target) retirement date, are an example of a type of fund that is rebalanced automatically. You don’t have to do anything.
A fund for investors with a target retirement date of 2040, for example, might have a starting target asset allocation of 90% stocks and 10% bonds. The fund’s managers will rebalance the fund as often as needed to maintain that target allocation. In addition, they will shift the fund’s asset allocation over time, making it more conservative through 2040. These funds typically have low expense ratios; the industry average was 0.52% in 2020, according to Morningstar.
What about balanced mutual funds? Also called hybrid funds or asset allocation funds, these are similar to target-date funds in that they hold both stocks and bonds and aim to maintain a specific allocation, such as 60% stocks and 40% bonds. However, that allocation doesn’t change over time; balanced funds are for investors of any age.
Working with a robo-advisor requires virtually no time or skill on your part: The robo-advisor does all the work automatically. All you have to do is open an account, put money in it, and choose your target asset allocation or answer the software’s questions to help it set a target asset allocation for you.
Costs are low, too. Robo-advisors such as Betterment, Wealthfront, and SigFig use strategies to make rebalancing less expensive by avoiding or minimizing short- and long-term capital gains taxes. A common strategy is to avoid selling any investments when rebalancing your portfolio. Instead, when you deposit cash or receive a dividend, the robo-advisor uses that money to purchase more of the investment you’re underweight in.
If, for example, your portfolio has drifted from 60% stocks, 40% bonds to 65% stocks, 35% bonds, the next time you add money to your account, the robo-advisor will use your deposit to buy more bonds. By not selling any investments, you don’t face any tax consequences. This strategy is called cash flow rebalancing.
You can use this strategy on your own to save money, too, but it’s only helpful within taxable accounts, not within retirement accounts such as IRAs and 401(k)s. There are no tax consequences when you buy or sell investments within a retirement account.
Another strategy robo-advisors use to keep transaction costs low is to sell whichever asset class you’re overweight in any time you decide to withdraw money from your portfolio.
Further, when your robo-advisor rebalances your portfolio, you won’t incur the commissions, transactions, or trading fees that you might encounter when rebalancing on your own or through an investment advisor. Robo-advisors don’t charge these fees. Instead, they charge an annual fee based on the dollar amount of assets they manage for you.
Betterment, for example, charges an annual fee of 0.25% of assets under management and there’s no minimum account balance. And because robo-advisors are automated, they may rebalance your portfolio as often as daily, so it’s usually in near-perfect balance.
Hiring an Investment Advisor
If you hire someone to manage your investments, portfolio rebalancing is one of the tasks they’ll do for you, along with creating an investment plan based on your goals and risk tolerance and recommending investments to help you meet those goals.
It’s certainly possible to manage your investments and rebalance your portfolio yourself. But some people don’t have the time, aren’t confident in their ability to learn what they need to know and perform the right tasks, or just don’t want to deal with it. Other people know how to manage their own investments but find themselves making emotional decisions that hurt their returns. If you fall into one of these categories, hiring an investment advisor could pay off.
Hire a Fee-Only Fiduciary
This type of professional has no conflicts of interest that prevent them from acting outside your best interests. They are paid for the time they spend helping you, not for the specific investments they sell you or the number of trades they make on your behalf.
When choosing a fee-only fiduciary, check their background using the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck website and the Securities and Exchange Commission’s Investment Adviser Public Disclosure website. Depending on the type of advisor, you may be able to check their background at one, both, or neither of these websites.
If they do show up in one of these databases, you can see their work history, exams passed, credentials earned, and any disciplinary actions or customer complaints against them. You can also sometimes check an advisor’s credentials with the credentialing organization. You can verify, for example, an individual’s certified financial planner certification and background on the CFP Board’s website.
Cost Is the Biggest Drawback
The industry average cost is about 1.0% of assets managed per year. So, if your portfolio totals $50,000, you’ll pay your advisor roughly $500 per year. In addition, you’ll pay any commissions and fees associated with the investments in your portfolio. Paying any fees, including an investment advisor’s fees, will reduce your overall returns.
Some advisory services try to beat the industry average. Vanguard claims that on a $250,000 investment using the company’s Personal Advisor Services, which only costs 0.3% of assets under management per year, you would spend $187.50 in quarterly fees compared to an industry average of $625.
An Advisor’s Fee Can Pay for Itself
Investors tend to earn lower returns than the funds they invest in because of their tendency to sell low and buy high. A financial advisor’s behavioral coaching can overcome this problem. Working with an advisor can help you stay the course, especially in bull or bear markets when your emotions might tempt you to stray from your long-term investment strategy.
A study by Vanguard published in February 2019 found that through financial planning, discipline, and guidance—not through trying to outperform the market—advisors can increase their clients’ average annual returns by 3%.
Another reason to hire an investment advisor is if it’s going to mean the difference between actually having an investment plan or doing nothing. The latter is toxic to your long-term financial health.
You don’t have to hire someone on an ongoing basis; you can hire someone to help you on a per-project or hourly basis. Not all advisors work this way, but many offer the option. And you can hire someone anywhere in the country and speak with them online, by Skype, or by phone.
The seemingly free advice offered by some bank and brokerage employees and services may be compensated with commissions on the investments you purchase, which creates a conflict of interest that may dissuade them from recommending your best options.
Of course, there are also downsides to hiring an advisor, including the fact that many of them have investment minimums. You might not have enough assets for certain advisors to take you on as a client. Some services require that you have at least $500,000 to invest.
The funny thing about hiring an advisor to rebalance your portfolio is that they’re probably going to use an automatic asset rebalancing tool (in other words, software). This software accounts for the investor’s risk tolerance, tax goals (such as tax-loss harvesting and avoiding capital gains and wash sales) in the case of a taxable portfolio, and asset location (whether to hold certain investments in a nontaxable account such as a 401(k) or in a taxable brokerage account).
It’s expensive, sophisticated software that you wouldn’t buy on your own, yes. But robo-advisors also use the software. Why not, then, just hire a robo-advisor?
A Vanguard study published in May 2013, analyzing 58,168 self-directed Vanguard IRA investors over the five years ended December 31, 2012, found that investors who made trades for any reason other than rebalancing—such as reacting to market shake-ups—fared worse than those who stayed the course. If robo-advising won’t prevent you from buying high and selling low, then paying an individual investment advisor to make sure you stay disciplined with your investing strategy can pay off.
The Bottom Line
The first time you rebalance your portfolio might be the hardest because everything is new. It’s a good skill to learn and a good habit to get into, though. While it isn’t designed to increase your long-term returns directly, it is designed to increase your risk-adjusted returns.
For most people, taking a little less risk through rebalancing is a good thing because it keeps them from panicking when the market sours and helps them stick with their long-term investment plan. And that means the discipline of rebalancing can increase your long-term returns.
How Do I Rebalance My Portfolio?
The purpose of rebalancing is to ensure your investment portfolio is correctly weighted to suit your risk tolerance and financial goals. If you feel that your portfolio has become too risky or too conservative, you can take action to return it to your original asset allocation target by selling something you’re overweight in and replacing it with whatever is lacking.
Alternatively, if you don’t want to sell, consider depositing extra funds or using dividend payments to purchase more of the investments you’re underweight in until your portfolio meets your objectives again.
When Should I Adjust My Portfolio?
Generally, it’s advisable to check your portfolio every six months or so and only intervene if your asset allocation has deviated significantly from where it should be and basically left you with an unacceptable risk/return profile. It’s up to you to choose an exact threshold that shouldn’t be crossed. Vanguard reckons investors should act when their preferred asset allocation strays by 5%, believing that this level strikes the best balance between risk management and minimizing costs.
Can You Rebalance Too Often?
Rebalancing your portfolio frequently is not necessary and often counterproductive. Endlessly buying and selling results in higher costs that eat into your returns. Watching your portfolio like a hawk can also encourage panic transactions and a hefty short-term capital gains tax bill.