How to Develop a Solid Annual Rebalancing Plan

What is an annual portfolio rebalancing plan, and why do you need one? When you first construct a portfolio, the assets are balanced according to your investment objectives, risk tolerance, and time horizon. However, that balance, known as “weighting,” will likely change over time depending on how each segment performs. If one segment grows at a faster rate than the others, then your portfolio will eventually become overweighted in that area and may no longer fit your objectives.

Rebalancing the portfolio avoids this overweighting, preserving your desired weighting over time. It is an important step to examine your portfolio annually—by yourself or with your financial advisor—to determine what, if anything, needs to be rebalanced going forward into the next year. Depending on market volatility, you may need to rebalance more often than once a year.

How an Annual Portfolio Rebalancing Plan Works

In its simplest form, a rebalancing strategy will maintain a portfolio’s original asset allocation by selling off a portion of any segment that is growing faster than the rest and use the proceeds to buy additional portions of other portfolio segments.

For example, assume that you create a portfolio composed of 50% stocks, 40% bonds, and 10% cash. If the stocks grow at a rate of 10% per year and the bonds at a rate of 5%, stocks will soon account for more than 50% of the portfolio.

A rebalancing strategy would dictate that the excess growth in the stock portfolio be sold off and the proceeds directed to the bond and cash segments to preserve the original asset ratio. This strategy also leverages the selling off of the better-performing segments when their prices are high and buying others when their prices are lower, which improves the overall return over time.

Rebalancing can be most effective when markets are volatile because the portfolio cashes in on winning stocks and picks up under-priced holdings at a discount. Some rebalancing strategies are tighter than others: one might rebalance if the portfolio becomes 5% overweighted in one sector, while another may allow for up to 10% overweight.

Estate Planning and Taxes

At the same time, when you rebalance your portfolio, you might also want to use this as an opportunity to make adjustments for estate planning purposes. For example, the Setting Every Community Up for Retirement Enhancement (SECURE) Act stipulates that certain non-spouse beneficiaries of inherited IRAs must take distributions by the end of the 10th calendar year following the year of the IRA owner’s death (exceptions are made for eligible designated beneficiaries). Note that is if the original owner died on or after Jan. 1, 2020.

If the original owner died on Dec. 31, 2019, or before, and died before 70.5 years old, the beneficiary can start taking RMDs no later than Dec. 31 of the year following the death. The beneficiary may be able to use the 5-year rule, which allows any amount of distributions as long as assets are completely distributed by Dec. 31 of the fifth year following the original owner’s death. 

Now, if the original owner died before Dec. 31, 2019, and was 70.5 years old or older, the beneficiary can calculate RMDs using their own age or the original owner’s age in the year of their death (whichever was longer). This is advantageous if the original owner was younger than the beneficiary.

Inheriting IRAs means your beneficiaries could be impacted by an unexpectedly high tax bill depending on when they take distributions and the overall value of the inherited IRA. If one of your goals is to leave your portfolio assets to your spouse, children, or other beneficiaries to provide for them should you die, you’ll need to be aware of and plan for the tax consequences they might encounter based on how your portfolio and retirement assets are structured.

Consider the Costs

Rebalancing can also be done at more frequent periodic intervals, such as every quarter or six months, regardless of market conditions. However, the more often a portfolio is rebalanced, the higher the commissions or transaction costs. Also, some investment custodians may limit shifting money from one fund or asset class to another to a certain number of times per year.

One way to cut fees is by enlisting the services of a recently emerged robo-advisor. These automated services perform basic money-management chores—such as portfolio rebalancing—at a fraction of the cost of a human advisor. There are several now available to consumers, and their asset base is growing rapidly.

Another consideration with rebalancing is that for taxable accounts, any investments sold at a profit are subject to capital gains taxes.

The Bottom Line

Rebalancing is basically about managing risk. For example, if your original portfolio was composed of 60% and 40% bonds, in a strong equity market where stocks grow (and without rebalancing), the ratio may become skewed toward stocks. Such a stock-heavy portfolio lacks diversity and is much riskier. This might be fine for those with a high tolerance for risk and a long risk horizon, but it could be bad for someone who wants to retire in the next year or two.

Portfolio rebalancing can help you to preserve your original asset allocation and reduce your amount of risk. It can also improve the overall return of your portfolio over time with less volatility. Most money management services, mutual fund companies, and variable annuity carriers offer this service, sometimes for free. For more information on how rebalancing can help your portfolio, consult your financial advisor.