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Portfolio rebalancing is a simple trick that retirees can use to sleep better at night. When you know your asset allocation is in line with your financial objectives and risk tolerance, you’re less likely to fall prey to the anxiety of running out of money or losing everything in a market crash.
research from vanguard Shows that consistent asset allocation improves long-term performance and helps keep risk under control. That’s why it’s important for retirees to check portfolios from time to time, especially when stocks are at all-time highs.
How does rebalancing work?
Imagine you have a $500,000 portfolio and you allocate 60% to stocks and 40% bonds. This would give you $300,000 in stocks and $200,000 in bonds.
If stocks rise 30% while bonds remain stable, you will have $390,000 in stocks and $200,000 in bonds. This would change your allocation to 66% stocks and only 34% bonds.
Although it may not seem like a big difference, your portfolio will now be exposed to more risk and volatility. A market selloff can do more damage to your portfolio than you thought when designing your target allocation.
To rebalance your portfolio to its desired 60/40 allocation, you need to transfer $36,000 from stocks back to bonds. This will leave you with $354,000 in stocks and $236,000 in bonds.
tax considerations
Unless you keep your investments in a tax-deferred account, such as a traditional IRA or 401(k) plan, you’ll need to take taxes into account when rebalancing.
Long-term capital gains are generally taxed at rates of 0%, 15% or 20% depending on income level. If you’re single and your taxable income is less than or equal to $48,350, or $96,700 for joint filers, your long-term capital gains rate will be 0%. This means your rebalancing will not attract any capital gains taxes. However, if your taxable income is high, you should carefully consider the benefits of rebalancing against the potential tax costs and avoid selling positions frequently.
Steps to Rebalance
Rebalancing is simple, but there are some steps you shouldn’t overlook.
- First, create a target allocation in line with your investment objectives and risk tolerance.
- Next, review your portfolio annually or semi-annually, ensuring that it matches your target allocation.
- Rebalance if any part of your allocation rises or falls by more than 5% from its original target.
- Keep in mind the tax consequences of frequent rebalancing; Use tax-advantaged accounts whenever possible.
- Consider adding funds to your allocation to boost underperforming sectors.
If you take these steps to keep your allocation balanced, you can sleep easy knowing that your portfolio is in line with your objectives.
Editor’s Note: This article is for informational purposes only and does not constitute financial advice. Investing involves risk, including possible loss of principal. Always consider your individual circumstances and consult a qualified financial advisor before making investment decisions.