Investor Ed: Two Ways to Rebalance Your Portfolio

INVESTING WOULD BE SO MUCH EASIER if you could plan for your financial future against a backdrop of stable markets and foreseeable global events. Yet the reality is far different. Industries or geographical regions that appear to be reliable growth opportunities or safe havens one year may be disrupted the next year by game-changing innovations or geopolitical unrest. And investments that made perfect sense one year may need rethinking the next.

In addition, the various asset classes—typically stocks, bonds and cash—that make up your portfolio can perform differently over time, creating an unintended “drift” in your preferred asset allocation, or the percentage of your portfolio invested in various asset types.

As a result, your portfolio could become more heavily weighted toward equities than you’d like, and less so in bonds and cash. Because equities tend to be the riskiest of these three asset types, this could leave you exposed to more risk than you’re comfortable with. And the opposite is also true: In a period when bonds are performing well, you could be less exposed to the long-term growth that equities have historically provided.

For all of the above reasons, many investors make a habit of checking their portfolios regularly and correcting any imbalance. That process of constant review and adjustment is called rebalancing, and it’s more important now than ever to help you keep your portfolio from falling out of line with your long-term strategy.

In the past few years, the rapid pace of global change has shifted into overdrive, says Marci McGregor, Chief Investment Office, Merrill and Bank of America Private Bank. “Today, it’s critical to review and adjust portfolio positions at least once a year and sometimes more often.”

As important as rebalancing is, however, investors often are reluctant to do it, McGregor notes. That’'s because rebalancing can mean selling investments that have done well, which is painful. “Rebalancing involves paring back some of those assets that have become a larger portion of your portfolio, and investing in others that have dropped,” she says.

How you choose to rebalance can depend on several factors, including your comfort with risk, your investment time horizon and cash flow needs, and also how often you prefer to meet with your advisor. “These factors will be different for everyone,” says McGregor, who adds, “Rebalancing is about returning to your roadmap. It starts with having that strategic long-term plan in place, and then being disciplined about maintaining it.”

Here are two approaches that you could consider.

Periodic rebalancing. This involves checking on your portfolio at a preset time—such as each year or quarter—and making any necessary adjustments. Such a schedule can help make rebalancing a regular part of your investing routine. But keep in mind that market volatility doesn’t follow a schedule, and you might find yourself rebalancing after a calm period during which not much has changed or waiting too long to address a particularly volatile market.

“Tolerance band” rebalancing. With this approach, you commit to making adjustments every time an asset rises or falls outside of a limit, or tolerance band, you establish—for example, a change of 5% in either direction. While this method helps ensure timely attention when your portfolio needs it, it also requires closer monitoring and greater discipline than if you were simply reviewing your portfolio at the same time each year.

Choosing the method that works better for you may depend on your personal preferences and the complexity of your portfolio. For many investors, combining the two approaches may be useful, allowing you to respond as necessary when volatility spikes while also committing yourself to a review at least once a year. Your advisor can help you decide on an approach that is most appropriate for you, against the backdrop of today’s markets.