If you have only heard one piece of advice about how to structure your investments, it is to diversify. As the common refrain goes, you do not want to put all your eggs in one basket—after all, if you drop your basket (an all-too-common occurrence for klutzes like me), all your eggs break!
There are many ways to diversify your investments. You could invest in one or more total market funds (my favorite approach), sector funds, or target date retirement funds; purchase a variety of individual stocks and bonds; or some combination of these. Your investment allocation will depend on your preferences, goals, and risk tolerance.
“Funds” could be ETFs and/or mutual funds.
Determining your investment allocation is important, as is revisiting your ideal mix of investments from time to time. Initially choosing a balance of funds that meets your goals and risk tolerance sets you up for financial wellbeing. However, over time, you may find that some investments grow more than others, changing the percentage of your total portfolio invested in certain areas. The act of “rebalancing” your portfolio means revisiting your portfolio from time-to-time to make sure that you stay on your chosen path.
Charting your path is its own topic. Here, I focus simply on how to stay on that path.
What is rebalancing?
Rebalancing your portfolio means keeping your investment allocations—i.e., the percentage of your money you would like to invest in certain assets—on target.
For example, assume that you decide to allocate your investments as follows:
60% = Total United States stock market index fund
20% = Total United States bond market index fund
20% = Total international stock market index fund
100% = Total allocation
Over time, your investments will grow at different rates. One year later, based on the market values of your individual holdings, your actual portfolio might consist of the following, even though you are still investing according to your 60/20/20 allocation:
57% = Total United States stock market index fund
19% = Total United States bond market index fund
24% = Total international stock market index fund
100% = Total allocation
To stay on track with your desired allocation, you would simply sell 4% of your portfolio from the international fund, and use those proceeds to purchase 3% in the stock market fund and 1% in the bond fund.
Alternatively, if you are still working and actively buying more investments, you could choose to invest more in the stock market and bond market funds while investing slightly less in the international fund until the allocations evens out again. If you are someone who checks your investments monthly, this method may work for you. If you prefer to set your investments and forget it, the annual check-in where you buy and sell accordingly will likely work better for your investment style.
Why should I rebalance?
You should rebalance periodically because your actual allocation will not stay on track with your desired allocation.
If you want 5% of your portfolio to consist of Amazon stock, and Amazon has a very good year, it might suddenly comprise 15% of your portfolio! Do you really want that much of your portfolio to depend on one stock? It seems enticing because Amazon is doing so well, but then what happens if the company then has a very poor year? Now your overall portfolio suffers because you have overcommitted in one area.
In other words, your basket shifts periodically as the market does what the market does. Some investments will outperform others by unpredictable margins. Usually this happens over time, but sometimes the changes can occur rapidly, such as when an entire industry experiences a sharp decline, a natural disaster devastates a particular region, or there is a black-swan event like the 2008 financial crisis or a global pandemic.
If you are not paying attention, you could end up with most of your eggs in one or two baskets instead of spread evenly across four of them. Then disaster hits, completely spilling one of your two heavy baskets, and now you are left scrambling. (See what I did there?)
In Quit Like a Millionaire, Kristy Shen describes how allowing your portfolio to become misaligned with your goals will prevent you from achieving them. Periodic rebalancing of your portfolio—i.e., at least annually—will help keep you on track.
Do I need to rebalance each individual account?
Rebalancing can certainly be done on a per-account basis, but it only needs to be done on a portfolio-wide basis. Continuing with the above example, you could have one account with an 80/10/10 mix and another with a 0/50/50 mix. As long as you get 60/20/20 when you add their balances together, you are on track.
Tax implications will likely impact your per-account allocation and rebalancing. These implications include, for example, whether a particular account is an IRA or taxable brokerage. Remember that trading within an IRA has no tax consequences, but trading within a taxable brokerage account will generate capital gains and/or losses. Additionally, long-term capital gains are taxed at more favorable rates than short-term capital gains, and you might consider tax-loss harvesting when rebalancing. Be sure to work with a trusted tax advisor regarding any major transactions.
You stay on the trail when hiking through the woods. Do the same with your investments. Regardless of your chosen path, stay on it by regularly rebalancing your portfolio.
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