Remember how it took only one really determined kid in grade school to disrupt the whole class? If the teacher didn’t nip that behavior in the bud, the unruliness escalated. And it didn’t take long for the situation to spiral completely out of control.
Your investments can be a lot like that unruly kid. When one of them doesn’t “behave” the way you expect it to, the offender can disrupt your entire portfolio. Just like a teacher keeping order in the classroom, it’s your job to stay in control of your asset mix to make sure it continues to reflect your investment strategy. Rebalancing can help you do that.
Notes on the Blackboard. Most likely, one of your first investing assignments was to choose a mix of stocks, bonds, and cash equivalent investments for your portfolio that fits your time horizon, risk tolerance, and investing strategy. But, as market values rise and fall, the value of your investments and the percentages you allocated to each investment class can change. Over time, you may be taking on more or less risk than you’re comfortable with.
Rebalancing can restore your original asset mix. And, if your feelings about risk have changed, rebalancing can bring your portfolio in line with your current risk tolerance.
Watch Out for Bullies. When the markets don’t play nice and securities values drop, you may think ignoring your investments is the way to go. But a volatile market makes rebalancing periodically even more critical. Consider checking investment performance annually, semiannually, or even quarterly. If you find that your asset mix or your risk tolerance has changed, you’ll be able to rebalance your investments to match your objectives.
Rebalancing Lessons. One way to rebalance your investments is to direct a larger percentage of your new contributions to the asset class that’s lagging behind and underrepresented in your portfolio. With more money going into it, the underperforming asset class will gradually be returned to the percentage of your portfolio that you originally intended.
Another way to rebalance is by selling investments in the asset class that’s doing well and buying investments in the classes that are struggling. You may be reluctant to sell investments when their values are rising. After all, who wants to dump winners to buy investments that are languishing? But reminding yourself that you chose your asset allocation to reflect your risk tolerance, time horizon, and investment objectives can put rebalancing in perspective. You may want to stick with your original mix unless you have solid reasons for changing your plan.
*Rebalancing a portfolio may create a taxable event if done outside a tax-favored retirement account.