Why Portfolio Rebalancing Makes Sense

PUBLISHED JANUARY 2024

Imagine driving on a straight highway with your eyes closed. No matter how precisely you grip the steering wheel, you need to open your eyes every so often as the car naturally drifts, making occasional adjustments to stay on course or risk eventually veering off the road. 

The same scenario applies to investing. 

Asset allocation in a portfolio is constructed based on an investor’s goals, risk tolerance and time horizon. It’s the course investors set for their financial futures. However, natural market movements will cause the portfolio’s allocation to shift over time, especially during volatile periods like the markets have experienced over the past several quarters. 

Periodic rebalancing of the portfolio not only realigns the allocation back to its original target but can also present additional investment opportunities. 

Rebalancing is part of overall wealth management maintenance. It’s important to remember portfolio rebalancing is about managing risk. If a portfolio becomes heavily concentrated in assets that have performed well over time, the investor could be creating greater exposure for themselves, especially if market conditions change and those assets don’t continue to perform the way they did in the past. In this scenario, it may make sense to sell some of those concentrated positions and redirect the proceeds to other investment opportunities that represent balancing rates of return and realign the portfolio to its intended objective. 

It’s important that you work with financial planning and portfolio management officers as a team to ensure that your investment portfolio is appropriately allocated to deliver a risk/return balance that is aligned with their unique comprehensive wealth plan. This requires taking an aggregate view of your entire investment picture, not just one account.  

Make Sure It’s Comprehensive

All investment accounts should be considered when initiating a rebalancing strategy. For example, retirement vehicles like IRAs or 401(k) accounts could be overlooked because those investments may not be actively monitored on a consistent basis. In fact, IRAs and 401(k)s may offer rebalancing opportunities without triggering any capital gains tax impact.  

Remember, too, that there may be tax advantages in rebalancing, especially with taxable investment accounts. Securities may become highly appreciated over time, presenting a significant capital gains tax hit when finally sold. That capital gains cost could be spread over time with rebalancing. 

Another strategy to minimize tax impacts from an overweight position in highly appreciated securities could be to gift a portion of the position to a qualified charity. This would reduce a concentrated portfolio position while possibly offsetting a large capital gains tax. Investors should talk with a tax professional about strategies around the charitable gifting of appreciated securities. 

How often should a portfolio be rebalanced? Since rebalancing helps investors manage the risks of an investment strategy, determining how often to deploy a rebalancing strategy is important. Some investors opt for a rebalancing schedule based on when assets within the portfolio shift by a predetermined amount. Others may prefer a calendar approach to rebalancing when they are doing other financial-related tasks like preparing taxes. 

Portfolio rebalancing is an important component of investment management that is influenced by multiple factors. It is essentially an exercise that should take place periodically to not only maximize returns but also manage risk, keep investments aligned with a portfolio strategy, and help investors stay on track to meeting their financial goals.