Why you should be checking your allocation just as much as – if not more than – your performance.
Balancing how much of each asset class you should include in your retirement portfolio is one of your most important tasks as an investor. Ideally, you should strive for a combination of investments that are in line with your risk tolerance.
You probably check in on your performance fairly regularly. Do you do the same for your asset allocation? If you haven’t been thinking much about your asset allocation – or haven’t been thinking about it at all – I’d encourage you to consider rebalancing.
How does a portfolio get “unbalanced”?
Time spent in the market causes changes in your portfolio. If stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want.
For example, Let's say you initially decided on an 80% to 20% mix of stock investments to bond investments. If stocks perform well, you might find after several years that your portfolio is now divided 88% to 12%. On the other hand, if stocks haven't done well, you might have a 70-30 ratio of stocks to bonds in this hypothetical example. (This example is for illustrative purposes only, and does not represent any actual portfolio.)
You might find your portfolio has exceeded your risk tolerance.
Buying low and selling high
One simple way to bring your portfolio back into alignment is to sell some of your over-weighted, high performing assets, and reinvest in some of the under performing assets. You can think of it as “buying low and selling high” while staying in line with your core allocation. Historically, different asset classes do not act in concert with each other – that’s why we encourage diversification to begin with. With this method, you’re still exposed to a variety of asset classes that were selected with your particular goals, timeline and risk tolerance in mind.
If you’re rebalancing in a taxable account, you may create a taxable event. For example, selling investments as part of your rebalancing strategy might trigger capital gains tax and/or (in the case of a mutual fund) redemption fees. On the other hand, if you’re rebalancing a tax deferred retirement account like a 401(K) or an IRA, there is less of a concern.
How often to rebalance
That's why it's important to review your portfolio periodically to make sure your asset allocation is still appropriate for your current situation and financial goals. Doing a checkup at least once a year can help keep your portfolio on track.
*Caution: The example above is for illustrative purposes only and does not represent the actual returns of any investment or portfolio.