Rebalancing: The Simple Way to Keep Your Investment Plan on Track

The best investment strategies are fairly easy to maintain.

Once you’ve figured out how much to save, which accounts to use, and what your asset allocation should be, it’s primarily a matter of choosing a few low-cost index funds to implement your plan and letting it ride. For the most part, you should be ignoring the ups and downs of the market and focusing all your energy on putting more money into your accounts.

But even the best investment plans require a little bit of maintenance, and rebalancing is one of the most important ongoing tasks that keeps your plan on track.

What Is Rebalancing?

Every good investment plan starts with a thoughtful decision about your asset allocation. That is, what percent of your money do you want in high-risk, high-return investments like stocks, and what percent do you want in lower-risk, lower-return investments like bonds?

That one decision ends up determining about 90% of your overall investment risk and return. The specific investments you choose – the mutual funds, ETFs, stocks, and bonds – matter as well, but they’re not the driving factor.

In other words, your asset allocation is important and rebalancing is the process by which you keep your asset allocation in line through the ups and downs of the market.

As an example, let’s say that you decide on an asset allocation of 70% stocks and 30% bonds. And let’s also say that you have $10,000 invested in your 401(k).

To keep things simple, you put 70% of your 401(k), or $7,000, into a single stock market index fund, and 30% of your 401(k), or $3,000, into a single bond market index fund. With those moves you’ve nailed your target asset allocation.

However, over time the markets will move and your investments will naturally drift out of balance. Let’s say that over the course of the year stocks return 20% and bonds lose 10%. Without accounting for contributions, your 401(k) would look like this at the end of the year:

  • $8,400 in stocks
  • $2,700 in bonds

You haven’t made any changes, but now 75% of your money is in stocks and only 25% of your money is in bonds. You’ve drifted from your target asset allocation.

In order to bring your portfolio back in balance, you have to move $630 from your stock market index fund to your bond market index fund. Then you’re back at 70/30, and back on track.

That’s rebalancing.

What Are the Pros and Cons of Rebalancing?

So the big question here is this: Why even bother rebalancing? Why not just let your investments rise and fall with the market?

It all comes back to the main reason behind choosing an asset allocation in the first place. Essentially, it’s a risk management technique that balances your desire for long-term returns with your appetite for risk along the way. More money in stocks means the potential for higher returns, but greater risk for big losses. More money in bonds means less potential for high returns, but more certainty about getting them.

And rebalancing is simply the process by which you maintain your desired balance between risk and return. To put it another way, NOT rebalancing allows the ups and downs of the market to make your portfolio either too aggressive or too conservative, potentially making it harder to reach your investment goals.

The one downside, if you can really call it that, is that rebalancing typically leads to lower returns than not rebalancing.

The reason is that stocks tend to provide better long-term returns than bonds, meaning that most portfolios tend to naturally get more aggressive over time as the stock portion of the portfolio increases by more than the bond portion. This means that most rebalancing activity involves selling stocks in order to buy bonds, shifting you back to a more conservative portfolio with lower expected returns and less risk.

And while that may sound like a negative, remember that you’re shifting your portfolio back to the asset allocation you purposefully chose from the start. You already decided that the risk/return characteristics of that asset allocation were preferable to a more aggressive portfolio, so all you’re really doing is bringing things back in line. The sacrifice in return was expected to begin with.

With that said, there are circumstances in which rebalancing can actually increase your returns. That will tend to happen in a declining stock market – imagine the opposite of the previous example, with stocks falling 20% and bonds rising by 10%. Rebalancing in that scenario would mean buying more stocks, which have a higher expected long-term return. It can also happen when you rebalance between two investments with similar expected returns, such as U.S. stocks and international stocks.

But by and large rebalancing is a technique that prevents your portfolio from getting too risky, not something that provides superior returns.

How to Rebalance Simply and Effectively

The good news is that rebalancing doesn’t have to require a lot of effort. Here is a process you can follow to do it simply and effectively:

  1. If you either use an all-in-one fund or a robo-advisor, you likely don’t have to rebalance because it’s already being taken care of for you.
  2. Otherwise, setting a calendar reminder to rebalance once per year is often enough for just about everyone.
  3. Remember that you don’t have to match your target asset allocation in every single account. It’s your overall asset allocation across all accounts that matters. Any individual account can be different as long as the overall sum adds up.
  4. With that in mind, add up all your money in stocks across all investment accounts and all your money in bonds across all investment accounts (any money in cash can be counted as bonds). Divide each amount by your total investment balance to determine what percent of your money is in each category.
  5. If you are within a couple percentage points of your target asset allocation, no action is necessary.
  6. Otherwise, figure out how much money you have to move from stocks to bonds (or vice-versa) in order to get back to your target asset allocation. You can do this by multiplying your target stock percentage by your total investment balance and subtracting that number from your current stock balance.
  7. If possible, make any necessary trades within tax-advantaged retirement accounts so that you aren’t taxed on the transaction. Further prioritize accounts that are free to trade in order to minimize costs as much as possible.
  8. Once you’re done, set another calendar reminder for next year and get back to saving more money!

While the first time through may take a little bit of time, you should be able to complete this process in no more than an hour once you get used to it. And since you only have to do it once per year, it’s a small time commitment in order to keep your investment plan on the right track.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

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Matt Becker

Contributor for The Simple Dollar

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money where he helps new parents take control of their money so they can take care of their families. His free time is spent jumping on couches, building LEGOs, and goofing around with his wife and their two young boys.