By any reasonable standard, it's time to rebalance--to cut down your portfolio's equity weighting in an effort to reduce risk in your portfolio before the market does it for you.
Yet if you're like many investors, you've been reticent to rebalance. Inertia is an incredibly powerful force, and selling what's been working best in a portfolio runs counter to human instinct. We want to send more money to the winners in our portfolios, not take away from them.
And let's not forget the elephant in the room, the so-called TINA ("There is no alternative") argument. The alternatives to stocks--bonds and cash--don't particularly compel right now. Yields are still meager, while bonds court interest-rate risk.
Yet rebalancing can deliver some powerful benefits--risk reduction, cash-flow production, and/or possible returns enhancement, depending on the type of rebalancing you engage in. Nor does rebalancing need to be a complicated, spreadsheet-assisted affair, especially if you already have your portfolio saved on Morningstar.com. The following steps can help you rebalance quickly and painlessly.
Step 1: Determine what you're trying to accomplish.
The first step in the rebalancing process is deciding what you'd like to achieve with rebalancing. That, in turn, can help you identify what type of rebalancing you engage in.
The goal: Volatility and/or risk reduction
Rebalancing prescription: Asset-class rebalancing
If reducing risk in your portfolio is top of mind--you're concerned about market valuations, you know you get jittery during falling markets, and/or you're getting ready to retire--traditional rebalancing among asset classes, such as reducing stocks in favor of bonds, is the right strategy for you. This type of rebalancing tends to reduce risk but won't necessarily enhance returns
. That's because periods in which stocks outperform bonds (risk-reduction opportunities) outnumber periods in which bonds outperform stocks (returns enhancement opportunities).
In light of the fact that risk reduction is the main benefit of this type of rebalancing, very volatility-insensitive investors needn't make too big a deal of it. If during the financial crisis or periodic market blips you found yourself bellying up to buying opportunities rather than fleeing the falling market, rebalancing isn't essential.
Life stage is important here, though. Even if you're a notably calm and collected 62-year-old equity investor, if you're closing in on retirement, rebalancing is probably a good idea. That's because new retirees with big equity weightings are particularly vulnerable to bad returns at the outset of their retirements: If they're actively spending from their equity portfolios as they're declining, that has a demonstrated negative effect on the portfolio's sustainability. Use your anticipated portfolio spending to help determine the appropriate allocations you should have to stocks, bonds, and cash, as discussed here
. If you don't have enough of the safe stuff, trimming stocks and moving the money into bonds and cash is a smart strategy.
The goal: Return enhancement
Rebalancing prescription: Intra-asset-class rebalancing
If enhancing returns, rather than reducing risk, is a key goal, rebalancing within
asset classes can be a beneficial strategy. The basic idea is that investment styles zip in and out of favor; periodically pulling back on those that have performed well, as large-growth stocks have recently, and sending money to those asset types that have underperformed, like small value, can build a contrarian element into a portfolio. That has the potential--but not the guarantee--to enhance returns.
Investors can also consider rebalancing among geographies. While foreign stocks have performed well so far in 2017, thanks in no small part to appreciating foreign currencies relative to the dollar, in years past they've been clobbered by U.S. names. That sort of persistent underperformance can provide smart rebalancing opportunities. Investors can further fine-tune their rebalancing efforts by rebalancing between developed- and developing-markets stocks; my ETF model portfolios
hold developed- and developing-markets ETFs for this very reason.
The Goal: Cash-flow production
Rebalancing prescription: Asset-class and intra-asset-class rebalancing
Rebalancing can serve another valuable role for retirees: It can help them find cash for living expenses. With yields still low across asset classes, many retirees have scrambled with traditional income-centric strategies. My advice, as laid out in this article
on maintaining a bucket approach to retirement portfolios, is to not focus disproportionately on income production when building your in-retirement portfolio. Rather, be content with the 2%-3% organic yield on a traditional, non-income-focused portfolio, then periodically rebalance to harvest any additional living expenses needed. Today, retirees in search of income can find cash hiding in plain sight in the form of appreciated equity holdings. They can source their cash flows and/or fulfill required minimum distributions by focusing on their most highly appreciated equity holdings--probably those in the large-growth square of the style box.
Step 2: Find your current asset allocation and sub-asset-class exposures.
Once you've determined your rebalancing goal and what type of rebalancing you plan to engage in, take a look at your current portfolio allocations. Morningstar's Instant X-Ray tool
helps you size up your portfolio's actual exposures based on your portfolio holdings. Instant X-Ray doesn't simply take a large-blend fund and slot it in the large-blend square of the style box; rather, the tool looks at each holding's actual composition and slots in the asset-class pie and investment-style box accordingly. For an investor who owns Vanguard PRIMECAP Core
, for example, X-Ray puts about a third of the portfolio in both the large-blend and large-growth squares of the style box; it allocates smaller amounts to large-value and mid-cap stocks.
Step 3: Compare your allocations to your benchmarks.
Armed with your portfolio's true exposures, you can then compare them to your targets. All investors should be operating with some type of blueprint for their portfolios' asset-class exposures. A financial advisor can help you customize your asset mix based on your own situation, or you can look to age-appropriate target-date funds
and/or Morningstar's Lifetime Allocation Indexes
If you're engaging in rebalancing within asset classes, you'll need some benchmarks, too. A total market index can help you gauge style exposures: Today, most such indexes hold roughly 24% in each of the large-cap squares of the Morningstar Style Box, 6% in each of the mid-cap squares, and 3% apiece in the small-growth, -blend, and -value boxes.
If you're managing your portfolio's geographic exposures, the U.S. currently constitutes about 53% of the globe's total stock market value. Meanwhile, roughly 9% of the globe's market cap is designated emerging and the remainder developed.
Step 4: Focus on tax-sheltered accounts
Selling appreciated securities can lead to tax consequences if you're doing so within a taxable (i.e., non-retirement) account. That's why it makes sense to concentrate any rebalancing efforts within your tax-sheltered accounts, where you won't face tax consequences for switching things up. While you don't want to get in the habit of over-trading in your 401(k) or other company retirement plan, where you can dodge both tax and transaction costs when you make trades in such accounts, you may also be able to do so within your IRA.
If your taxable account looks particularly problematic--for example, it has way too much equity risk and you plan to retire soon--mind tax costs before scaling back highly appreciated positions. Investors in the 10% or 15% tax bracket
currently pay a 0% capital gains rate, but everyone else is on the hook for capital gains tax. In lieu of triggering a tax bill, see if you can't address your asset-allocation issue by steering future contributions into the underweighted areas of your taxable account. Alternatively, use the specific share identification method when harvesting winners, earmarking high-cost-basis lots for sale rather than lower-cost-basis ones.
Step 5: Identify specific candidates for pruning and additions.
Finally, identify specific holdings for pruning and addition. Even if your main rebalancing goal is to reduce risk by scaling back your equity exposure, you can also be savvy about which stock holdings you scale back on and which you add to. As noted above, large-growth stocks have enjoyed a strong runup so far in 2017 and therefore may be particularly ripe for pruning. Meanwhile, the tamest bonds (short-term and high-quality) have performed the worst.
You can also use rebalancing to address trouble spots in your portfolio--for example, trimming the stock that represents an overly concentrated position, or selling the equity fund that has seen a succession of portfolio managers in recent years. In so doing, you can reduce risk and improve your portfolio's fundamentals at the same time.