If you haven't reviewed your investment portfolio lately, you may be surprised at what you find. Even if you haven't made a single change to your investment mix, it’s possible your asset allocation has shifted from what it was when you first set it up. (Asset allocation does not assure a profit or protect against a loss.)
This shift, also known as “portfolio drift,” can significantly increase your portfolio’s risk and cause it to become misaligned with your target allocation. It happens when one or more asset classes or investments outperform or underperform others. This is especially true during times of heightened volatility like the markets are currently experiencing today. To fix the problem, you'll need to periodically review and rebalance your portfolio so that it reflects your desired allocation and risk profile. (Rebalancing strategies may involve tax consequences, especially for non-tax-deferred accounts.)
Portfolio Drift Happens
Your choice of investments and market conditions are two main factors contributing to the potential for portfolio drift. Over time, due in part to normal market fluctuations, asset classes tend to have varied, intermittent rates of return. Given this, it's not difficult to imagine that an allocation to stocks that started at 50% could eventually make up considerably more—or less—than 50% after years of out- or underperforming other asset classes in your portfolio.
Consider what happened to the stock market during the 2008-2009 market crisis. In the years leading up to the crisis, U.S. stocks were outperforming many other asset classes by a significant margin. On October 9, 2007, the Dow Jones Industrial Average hit its pre-crisis high of 14,164. But by March 5, 2009, just 17 months later, it had plummeted more than 50%.
In this scenario, the impact on investors with an allocation to stocks was twofold: the uptick in portfolio values prior to the crash spelled good news as they saw their net worth increase in the short term, but it also may have raised their allocation to stocks to a level they were no longer comfortable with. When the market crashed, those who had failed to rebalance their portfolios to adjust for the pre-crisis run-up in stocks may have been hit especially hard.
Many investors dislike rebalancing because it means selling winners in favor of losers. But the flip side of that story is when you rebalance, you're selling stocks that have done well and therefore may be more expensive, and you're buying stocks that have underperformed and may be selling at bargain prices.
When Should You Rebalance Your Portfolio?
While staying mindful of the effect that market conditions can have on your target investment mix is critical, remember that portfolio reviews should always be focused on you: your time horizon, risk tolerance, and goals. That said, to maintain your target asset allocation consider reviewing your portfolio about once a year. Some investors choose to rebalance at the end of the calendar year when they're reviewing their investments with an eye toward year-end tax strategies. Others may choose a memorable date, such as a birthday or anniversary as their target.
Keep in mind that rebalancing can generate a variety of costs:
- Taxes. Capital gains taxes may be due if you are rebalancing within a taxable account.
- Transaction fees. To execute and process trades. For individual securities, these costs may include brokerage commissions; for mutual funds, costs may include purchase and redemption fees.
- Time and labor cost. These may include management and/or administrative fees when rebalancing is done by a professional investment advisor.
Aside from volatile markets, there are other times and circumstances that could trigger a portfolio review, such as:
- Getting married. Planning for two, but aligning for one set of financial goals.
- The birth of a child. You’ll have a lot less time, but more to plan for.
- Getting divorced. Subtracting one, rebooting your financial life.
- Losing a job. Consider your allocations carefully with an eye toward creating liquidity.
- Nearing retirement. This is a tricky time when vigilance and a steady hand on the tiller are crucial.
How to Rebalance Your Portfolio
Rebalancing your portfolio can be accomplished in one of two ways:
- Adding new money to the asset class that has underperformed.
- Shifting money from the overperforming asset class to the others.
Either way, you'll want to reduce allocations to investments that exceed your target allocation and increase allocations to investments in the underweighted asset.
Take a Holistic Approach
If you have multiple investment accounts, determine how your money is divided among asset classes in each account and then across all accounts, whether in taxable brokerage, mutual fund, or tax-deferred accounts.
To gain a full appreciation of your investment strategy, go beyond stocks and bonds and calculate the percentages you have in other asset classes, such as cash and real estate. In addition, you may want to evaluate your allocations to categories within an asset class. For example, in stocks, you might consider the percentages in foreign and domestic stocks. In fixed income, you might break your allocation into U.S. Treasuries, municipal bonds, and corporate bonds.
To make monitoring your asset allocation easier, consider setting a percentage limit of “drift,” say 5% on either side of your intended target, which would automatically trigger a review and possible rebalancing.
Smart Rebalancing Strategies
Simple ideas for reducing transaction costs and taxable gains when rebalancing.
- To avoid tax liability, rebalance using new money instead of moving existing money around.
- Make as many changes as possible in an account that charges low/no trading fees, such as a low-cost brokerage account or in tax-deferred accounts like IRAs.
- When using new money to rebalance, consider using lump-sum payments such as a bonus or tax refund.
By taking the emotion out of the investment process and focusing on your prospects for the future, you can create the best outcomes for yourself and your family. Speak with your Fifth Third advisor to set up a portfolio review.