Compare calendar and threshold rebalancing. Work through allocation drift, taxes, costs and contributions before deciding whether to trade.
July 15, 2024 · Financial Forte Staff
Historical article: prepared retrospectively using information available as of July 15, 2024.
An investment that performs well can become a larger part of your portfolio than you originally intended. That can feel like a welcome problem until you realize the portfolio now depends more heavily on the investment's future results. Rebalancing asks whether the mix still fits your plan, then considers how to restore it when needed.
Use a review process you can explain before the next headline arrives. A calendar-based review, an allocation threshold or a combination can provide structure. The goal is to manage the portfolio's intended exposure, with attention to taxes and costs, rather than repeatedly predict which investment will lead next.[1]
Check whether the target still fits
A target allocation describes how you intend to divide the money among investment categories. It should reflect the purpose of the assets, the time available and your capacity for loss. Returning to an old target makes little sense if the goal itself has changed.
For example, money previously intended for retirement in fifteen years may now be needed for a home purchase in two. That calls for a planning review before a rebalancing calculation. A change in the job assigned to the money is different from ordinary market drift.
If the goal remains the same, compare the current allocation with the target using the accounts that serve that goal. Looking at each account separately can hide the overall exposure. It can also lead to unnecessary trades if one account already offsets another within the intended household allocation.
Measure drift in dollars as well as percentages
Consider a simplified hypothetical portfolio worth $200,000, with a target of 60% stocks and 40% bonds. The starting amounts are $120,000 and $80,000. After an assumed period in which stocks rise 20% and bonds are unchanged, the values are $144,000 and $80,000, for a total of $224,000.
Stocks now represent approximately 64.3% of the portfolio and bonds approximately 35.7%. Restoring the 60/40 target at that total would mean $134,400 in stocks and $89,600 in bonds. Ignoring trading costs and taxes, that would involve shifting $9,600 from stocks to bonds.
This is an invented example, not a market forecast or a recommended allocation. It shows that rebalancing responds to the changed proportions. Selling some of the stock position does not require a prediction that stocks will fall. It reflects a decision about how much exposure the investor intended to maintain.
The investor should still consider the consequences of the sale. In a taxable account, a gain may create a tax cost. Inside a retirement account, the immediate tax treatment of a trade can differ, but investment and transaction costs still deserve attention. The account type affects implementation, not the need to understand the overall risk.[1]
Choose a review rule you can maintain
A calendar-based approach reviews the allocation at set intervals, such as twice a year. It is simple to schedule, but the portfolio can drift between reviews. A threshold approach checks whether the allocation has moved beyond a defined tolerance and may trigger action earlier. It requires a reliable way to monitor the proportions and a clear assignment of who checks them.
Suppose the hypothetical investor uses a five-percentage-point stock tolerance around the 60% target. At approximately 64.3%, the allocation has not crossed a 65% upper boundary. A rule that requires action only after crossing that boundary would not call for a trade merely because stocks rose. A scheduled review could still examine whether circumstances have changed.
Define the threshold carefully. Five percentage points around 60% is different from 5% of the target allocation. Written definitions reduce the chance of changing the rule after seeing a market result. They also make it easier for an advisor and client to understand the same instruction.
No review interval or threshold is best for everyone. Frequent adjustments can increase costs and administrative work. Wider tolerances permit more drift. Choose a process that fits the size, tax circumstances and purpose of the portfolio, then evaluate whether it is being followed rather than judging it solely by the next market move.
Consider cash flows before selling
New contributions can sometimes move an allocation toward its target without selling appreciated holdings. Withdrawals can also be coordinated with the allocation, subject to tax and account rules. These methods may reduce the trades needed, although they may not fully resolve a large imbalance.[1]
In the example, adding $16,000 entirely to bonds would create a $240,000 portfolio with $144,000 in stocks and $96,000 in bonds, exactly 60/40. That is different from transferring $9,600 inside the existing portfolio because the contribution increases the total by $16,000, while the internal transfer leaves the total at $224,000 before costs. The option works only if the investor has that new money available and the contribution is appropriate for the account.
If no new contribution is planned, waiting indefinitely for one is not a complete response to an allocation that exceeds the investor's comfort or capacity. Compare the cost of trading with the risk of maintaining the current mix. For example, a planned $4,000 shift would reduce the original $9,600 gap to $5,600 if values and targets were otherwise unchanged. A partial adjustment may also deserve discussion when taxes or restrictions make an immediate full change impractical.
Write down the target, review schedule, threshold definitions and implementation considerations. At the next review, begin with the goal, then calculate the drift and evaluate the available actions. Rebalancing becomes more consistent when it follows a decision process you understand, instead of a headline you feel compelled to answer.
Related reading
- An Election-Year Portfolio Review Without a Market Prediction
- Portfolio Income and Total Return Tell Different Stories
Have more questions about portfolio rebalancing and investment goals? Complete the Financial Forte questionnaire to get started on connecting with an advisor who can help answer your questions and explore next steps.
The contact invitation is current; it does not imply this contact path existed on the historical reference date.
Educational information, not personalized investment, tax, legal or benefits advice. Examples use hypothetical assumptions. Verify current rules and your circumstances before acting.
