How to rebalance your portfolio

Investing is not a 'set it and forget it' activity. Rebalancing is the discipline that keeps your risk in check and your goals on track.

Why Rebalancing is Necessary

Imagine you start with a portfolio of 80% stocks and 20% bonds. After a year, the stock market has a great run and the value of your stocks increases. Now, your portfolio might be 90% stocks and 10% bonds. You are now taking more risk than you originally intended. If a market crash happens, you will lose more money than your '80/20' plan allowed. Rebalancing is the process of selling some of those stocks (selling high) and buying more bonds (buying low) to return to your original 80/20 target. This systematic approach overrides human emotion and forces you to follow a successful investment strategy.

Methods of Rebalancing

There are two primary ways to rebalance: Calendar Rebalancing and Threshold Rebalancing. Calendar rebalancing is done on a set date every year (like your birthday or January 1st). Threshold rebalancing is done whenever an asset class 'drifts' by more than 5% from its target. For example, if your 20% bond target drops to 15%, you triggered a rebalance. For most individual investors, the calendar method is simpler and just as effective.

Rebalancing Without Selling

• The 'New Money' Method: If you are still contributing to your accounts every month, you can rebalance for free by using those new contributions to buy the 'underweight' asset. If you need more bonds, just direct your next three months of 401(k) contributions into the bond fund. This avoids the cost and tax implications of selling.
• The 'Dividend' Method: Set your dividends to go to a cash settlement fund, then use that cash once a year to buy the asset that is falling behind.

Tax Conscious Rebalancing

Always rebalance in tax-advantaged accounts (401k, IRA) first. Selling for a profit in these accounts has zero tax consequences. If you must rebalance in a taxable brokerage account, be careful about capital gains taxes; you might prefer to wait until you have new cash to add rather than selling winners and triggering a tax bill.