An effective way to stay on track with your financial goals is by regularly monitoring and rebalancing your portfolio. This can involve adjusting your asset mix to maintain the right balance between risk and return.
Over time, market movements can cause your portfolio to drift. Certain assets may grow faster than others, shifting your allocation and exposing you to more or less risk than intended. Rebalancing can bring your portfolio back in line, helping you manage risk and stay aligned with your long-term objectives.
Read on to explore best practices for portfolio rebalancing and tax considerations to be aware of. This is intended to be a high-level overview, and not a recommendation for your unique situation. Everyone’s plan is different, so it is important to consider all variables and develop a plan that works for you. A strategy discussed here may not work for you. For advice concerning your own situation please contact the appropriate professional.
What is portfolio rebalancing?
Portfolio rebalancing happens when you adjust the weighting of assets in your investment portfolio. It can help ensure your portfolio continues to reflect your risk tolerance, time horizon, and financial goals.
When you first started investing, you likely diversified your portfolio with a specific mix of asset classes, such as stocks and bonds, based on how much growth potential you were seeking and what you were investing for.
If a particular investment, like stocks, performs well, it may begin to take up a larger share of your portfolio than intended. A traditional 60/40 split between stocks and bonds could drift to 75/25, increasing your risk exposure and making your portfolio more vulnerable to volatility. On the flip side, if bonds outperform, your allocation may become more conservative, limiting potential growth.
Rebalancing helps prevent this drift by realigning your investments with your target allocation. It can help ensure your portfolio is working toward your goals, whether that is saving for retirement, a major purchase, or inheritance for family members.
How to rebalance your portfolio
Rebalancing your portfolio is a straightforward process. The core idea is simple: Sell assets that have outperformed and buy those that have lagged.
When it comes to how often to rebalance your portfolio, there are a couple of common approaches:
- Time-based: Rebalancing at regular intervals, such as quarterly or annually, regardless of market performance.
- Threshold-based: Rebalancing only when an asset class deviates from its target by a set percentage (5% or more, for example). This allows for more flexibility based on market shifts.
Here are some of the basic steps to rebalance your portfolio.
- Record
The first step is to document your current portfolio. List all your investments, including stocks, bonds, and funds, along with their current market value. Calculate what percentage each asset or asset class represents within your overall portfolio. Most investment platforms provide tools or dashboards to help with this, but you can also track it manually using a spreadsheet or on a sheet of paper.
- Compare
Compare your current allocation to your target allocation. This comparison allows you to spot which asset classes have drifted, either by outperforming or underperforming.
- Adjust
Once you’ve identified the imbalances, make the necessary adjustments to realign your portfolio. This could mean selling a portion of overperforming assets and using the proceeds to buy underperforming ones. Alternatively, you can direct new contributions toward the underweight asset classes to gradually bring your portfolio back into balance, without needing to sell appreciated assets and triggering potential capital gains taxes.
What is automatic portfolio rebalancing?
For investors who prefer a more hands-off approach to portfolio management, automatic rebalancing eliminates the manual work involved in the process. This is an increasingly popular solution offered by many digital advisors and investment platforms, where portfolio adjustments are made periodically by algorithms to ensure your portfolio stays aligned without requiring constant oversight.
When you meet certain thresholds or hit set intervals, the algorithms actively buy and sell assets to maintain your target allocation. Along with saving time, this approach helps eliminate emotional decision-making, which can lead to costly mistakes. It could be ideal for busy investors and those new to investing.
Tax implications of rebalancing your portfolio
While portfolio rebalancing is a key part of a disciplined investment strategy, it can have heavy tax consequences. Understanding how and when rebalancing triggers taxes can help you make more informed decisions and avoid surprises.
When an asset overperforms, selling it typically results in capital gains (depending on the type of account), which are taxed as short-term or long-term gains based on how long you held the asset:
- Short-term capital gains apply to assets you’ve held for a year or less, and you pay taxes on these gains at your ordinary income tax rate.
- Long-term capital gains apply to assets you hold for more than one year, and they are typically taxed at lower rates.
Here are three strategies to help minimize your tax liability when rebalancing your portfolio.
Rebalancing within IRAs or 401(k)s
An efficient way to avoid immediate tax implications is rebalancing within tax-advantaged accounts, such as Individual Retirement Accounts (IRAs) or 401(k)s. Since these accounts defer taxes until withdrawal, you can buy and sell positions within them without triggering an immediate tax liability. This can make them an ideal space to execute rebalancing trades, especially for portfolios with significant gains.
Using new contributions
As mentioned earlier, another tax-friendly strategy is to use new contributions to rebalance your portfolio. Instead of selling appreciated assets, simply direct any new investments such as ongoing deposits or dividend reinvestments, toward underweight asset classes. This strategy can be particularly effective for investors who regularly add funds to their portfolio.
Tax-loss harvesting
If rebalancing does trigger capital gains, tax-loss harvesting can help reduce your overall tax bill. This involves selling investments that have declined in value. You can use these losses to offset capital gains you’ve realized from selling assets that increased in value. For example, if you gain $5,000 from selling stocks to rebalance, you could sell a different investment that lost $4,000, reducing your tax liability to a $1,000 gain.
The IRS typically allows you to offset gains with losses dollar-for-dollar. Additionally, if your capital losses exceed your capital gains, you can deduct up to $3,000 of net losses against your ordinary income each year. Any remaining losses get carried forward to future years.
This strategy requires careful planning to avoid violating the IRS wash-sale rule, which disallows losses if you repurchase the same asset or “substantially identical” asset within 30 days.
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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes.
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