Asset allocation involves dividing your portfolio between different investment asset classes like stocks, bonds, and cash, and sub-asset classes like small, large, and mid-cap stocks. International bonds and investments, as well as growth and value-oriented stocks are often part of a well-diversified portfolio.
In order to maintain your target asset allocation through market ups and downs, it is important to periodically review your portfolio for rebalancing. If the actual allocation of one or more asset classes deviates from the target allocation by more than a specified amount, it is time to buy or sell holdings in that asset class to bring the target allocation back. allocation at its target level.
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Your portfolio should be reviewed periodically to see if rebalancing is needed. This should be done at least once a year, more often, for example semi-annually or quarterly, as appropriate.
There are several reasons why portfolio rebalancing is important to investors.
Maintain the right level of portfolio risk
One of the primary goals of asset allocation is to maintain the right balance between potential downside risk and potential reward across your portfolio. Over time, the performance of the different asset classes represented in your portfolio will fluctuate up and down depending on market and economic conditions. We have certainly seen it in the markets in 2022.
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Over time, these variations in performance will cause your actual portfolio allocation to differ from your target allocation. This can cause you to take too much or too little risk. After a significant gain in the market, you may find yourself over-allocated to stocks. This can expose your portfolio to a higher level of risk than desired if the markets go down.
Imposing investment discipline
Having a regular rebalancing schedule imposes a level of discipline on you as an investor. With the stock market having seen steep losses so far in 2022, rebalancing at regular intervals will likely lead to an increase in your portfolio’s allocation to equity-based asset classes. This inherently forces you to “buy low”.
On the other side of the equation, during a period of extreme market gains, it can be tempting to ignore your rebalancing regimen and just let your “winners roll”. That’s fine if it works, but this approach can expose you to additional downside risk when the markets inevitably reverse.
None of us are smarter than the markets. It’s no different this time. Reviewing your portfolio for rebalancing at regular, defined intervals can help you avoid the temptation to think you’re smarter than the market. You are not.
A reason to review your portfolio
Although it is undesirable for long-term investors to review their investments daily, they should review their portfolios at set regular intervals. This can go hand in hand with a regular rebalancing diet.
In some cases, you may be able to configure certain accounts to automatically rebalance at a set interval. This is common with 401(k) accounts. That’s great, but you’ll still need to review these accounts to make sure your investments are in line with your overall financial plan.
If you decide that semi-annually is the appropriate interval to review your portfolio for rebalancing, make it the period in which you review the performance of your portfolio and the investments held in the portfolio to see if any changes are needed.
Whether you keep your existing portfolio allocations or decide to adjust them, be sure to rebalance your portfolio to bring the asset allocation back to your target allocation.
A key part of your financial plan
Over time, as you review your progress towards your financial goals such as retirement, saving for college, and others, you may find that you are ahead of schedule or may be a bit behind what you hoped to be.
Your investments play a key role in helping you achieve your financial goals. You may determine that your target asset allocation needs to be adjusted to take on more or less risk based on a review of your progress against your financial plan. Once this decision has been made and any changes to your asset allocation have been made, it is important to continue reviewing your asset allocation for possible rebalancing on a pre-determined interval as you did previously.
Combine rebalancing with other tasks
Rebalancing can be implemented in a number of ways, beyond simply selling investments in asset classes with a higher than desired allocation and buying investments in asset classes under-allocated.
Allocate new money, including contributions to a 401(k) or similar employer-sponsored retirement plan, to asset classes that are under-allocated. This can help avoid triggering taxable gains in taxable accounts.
Collection of tax losses in taxable accounts, if appropriate to your situation. The proceeds can be used to offset any capital gains realized this year, a portion can be used to offset other income if needed and any unused losses can be carried forward.
Consider using shares of appreciated securities as charitable contributions to organizations that accept this type of donation. This can help reduce your allocation to an asset class that is over-allocated. The market value of donated securities can be used as a charitable deduction if you itemize your taxes. In addition, you will not have to pay capital gains tax as you would if the securities were sold for a realized gain.
Some studies have indicated that asset allocation is a more important factor in portfolio returns than stock selection. For this and other reasons, rebalancing your portfolio as necessary at regular intervals is a crucial part of the investment process.
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