FREE NEWSLETTER
THE YEAR’S MIDPOINT is here, with the stock market on track for its second consecutive year of above-average gains. This has many investors asking about rebalancing. Below are some commonly asked questions.
What is rebalancing? Let’s say that, to get the right mix of risk and return, you’ve settled on an asset allocation of 50% stocks and 50% bonds. Now, suppose the stock market rises 10%. This would lift stocks to some 52% of your total portfolio, instead of 50%. This is where rebalancing would come in. If you wanted to return your account to its initial 50%-50% split, you’d sell stocks and use the proceeds to buy bonds. That, in a nutshell, is how rebalancing works.
Why rebalance? When it comes to managing a portfolio, risk management should always come first, in my view. That’s the main reason you might want to rebalance. When you cut back on stocks, as in the example above, you reduce risk.
While risk management should be investors’ first priority, it isn’t the only one. Rebalancing tends to reduce a portfolio’s long-run growth, because it typically involves cutting back stocks. Still, it carries the potential to boost short-term returns. Suppose that, instead of rising, the stock market fell by 10%. The result in this case is that stocks would drop to about 47% of your portfolio. To get back to the original 50% target, you’d sell bonds and buy stocks. That means you’d be buying when stocks are at depressed prices and potentially set to rebound.
When to rebalance? There’s much debate on this topic. Some prefer to rebalance on a set schedule, such as quarterly or annually, while others rebalance only when the market has experienced a significant move. According to a survey of the research by author Mike Piper, the data on the topic is contradictory, which means that there isn’t one approach that’s guaranteed to be optimal. Personally, I prefer to rebalance only when it’s warranted by market movements.
If you’re in retirement and taking regular withdrawals from your portfolio, though, you could approach it differently. Retirees, whose portfolio has become too heavily weighted in stocks, could rebalance incrementally by taking each of their monthly withdrawals only from the stock side of their portfolio.
When it comes to the question of when to rebalance, the most important thing, in my view, is to avoid falling into the trap of recency bias—the mind’s tendency to extrapolate from recent trends. When investors see the market rising, it can be tempting to “let it ride” and avoid selling stocks. But it’s precisely at times like this that the discipline of rebalancing can be most helpful.
Where to rebalance? Suppose you hold stocks and bonds in more than one account. Where should you place your rebalancing trades? While every investor is different, there are some guidelines. For starters, there’s one account I’d never rebalance. If you have a Roth IRA, I’d keep it invested entirely in stocks at all times to maximize the tax-free growth.
On the other hand, if you have a tax-deferred retirement account, such as a traditional 401(k) or IRA, that would be the ideal spot to rebalance, because trades within these accounts don’t incur taxable gains.
The key is to view your portfolio holistically. If your target is to hold 50% in stocks, don’t feel the need to set every account to that same 50%.
How to rebalance? Once you’ve decided when and where to rebalance, the next question is how to do it. There’s a number of considerations.
First, it’s important to look at your portfolio through more than one lens. It’s good to have targets—such as 50% stocks—and to be diligent in rebalancing back to those targets. But it’s also important to look at your portfolio in dollar terms. Most important is to keep an eye on the dollars you hold in bonds because they’re your portfolio’s safety net.
Because bonds’ role is to meet withdrawals when stocks are down, you’ll want to regularly monitor your bond holdings relative to your needs in dollar terms. The reading on this gauge can help determine whether, and to what degree, there’s an urgent need to rebalance. Someone early in her career, who’s only adding to her portfolio, might not be as quick to trim risk when stocks rise. But a retiree who’s taking regular withdrawals might be much less tolerant of risk and thus quicker to reduce it.
A key question that many struggle with: Should you rebalance all at once or incrementally? There’s no surefire way to answer this question because, ultimately, we can’t know which way the market is headed—and thus we can never know in advance when the absolute optimal time is to rebalance. But taxes can provide a useful guide in making this timing decision.
If you’re rebalancing in a taxable account, and incurring capital gains as a result, you might use the capital gains tax brackets to help decide how much to sell each year. A 15% marginal bracket, for example, applies to capital gains when taxable income is below roughly $584,000 for a married couple or $519,000 for a single individual. While those numbers might sound high, keep in mind that they include all categories of income, including wages.
So, if you’re rebalancing, you might view the top of the 15% bracket as a cap and aim to defer any further gains into the following year. This way, you’d avoid ever paying the top capital gains rate, which is currently 20%.
Those with incomes below $100,000 can benefit from another tax threshold. For married couples with taxable income up to $94,000, or individuals with income up to $47,000, capital gains aren’t taxed at all. Folks in this 0% bracket might use the top of that bracket as their rebalancing cap each year.
And finally, married couples whose income is approaching $250,000, or single individuals with incomes nearing $200,000, should keep in mind the net investment income tax, which applies a 3.8% surtax on investment income above those thresholds.
When estimating your income for the year, don’t forget about dividends and interest, as well as capital gains distributions from mutual funds held in taxable accounts. Because these can be difficult to estimate, you might use the figures from your prior year’s tax return as a reasonable approximation.
What to rebalance? So far, we’ve discussed the question of rebalancing only at a high level, focusing on the split between stocks and bonds. But what if your portfolio contains more than one stock holding and more than one bond holding, which is the case for most people?
On the one hand, this makes rebalancing more complicated, but it also offers an opportunity, because it provides more levers with which to control capital gains. In trimming your stock exposure, you could sell a combination of some more highly and some less highly appreciated assets, or perhaps even assets with losses.
Another useful lens: Examine the breakdown of holdings within your stock holdings and within your bond holdings. When assessing a stock portfolio, you might look for concentrations that carry risk, such as a big holding in one stock, one industry or one geographic region. Meanwhile, within bonds, you might examine the breakdown along four dimensions: maturity, type, quality and geography. Don’t have the desired mix? That’ll make it easy to know what to sell.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
Another good article, Adam. Our industry has tried to make investing a science. It is not.
Rebalancing to a fixed allocation assumes that people’s risk profiles don’t change. The fact is, over time, an unbalanced portfolio will outperform a balanced portfolio due to the higher expected return on stocks.
So if you have more money by letting your stock allocation run unbalanced, you can also afford to lose more. Therefore, you have the capacity to take on more risk. This is often ignored.
If it makes you feel better to keep a standard rusk profile, then go for it.
But remember rebalancing does not improve returns over time. It keeps your risk level consistent. Which may or may not be appropriate.
If I am retired and accessing ROTH to control income (re:ACA subsidies), shouldn’t I keep a portion in short term bonds..say 3 yrs worth to ensure access when market is down? So I should be ROTH rebalancing correct?
You can sell stocks in Roth but then to rebalance you would sell bonds and buy stocks in traditional.
A good reminder to every investor. Rebalancing is a bit like pulling weeds in your garden: If you don’t do it regularly, your garden will quickly get out of control.
What I didn’t see in your comments was any mention of appropriate cash levels. At the moment, the penalty for holding a somewhat larger amount of cash is smaller than in recent years. That coupled with the strong run up in equity values and possible economic uncertainty after the 2024 election, may argue for a somewhat larger cash cushion.
I have contiued to keep my cash positions in taxable accounts small, but have increased my cash holdings in tax deferred accounts where I am not generating any capital gains.
You forgot to mention the additional Obamacare 3.8% capital gains tax when your income goes over 200K
Mike, he did address that under the “How to Rebalance” paragraph (the 3.8% net Investment income tax).
I see what you did there with the headline.
If you are a single retiree, and your income is above $200K, you don’t have much to worry about. Pay the taxes and be happy!
Another wonderful article! Thank you.
Disclaimer: I’m a big believer in rebalancing.
Adam, thanks for an excellent primer on rebalancing.