Your investment portfolio is the key to your financial freedom. Let me teach you how to rebalance your investment portfolio so you can sleep better at night and earn appropriate risk-adjusted returns.
When I talk about your investment portfolio, I'm talking about your after-tax, non-401k/IRA/Roth portfolios. It is this portfolio that will produce enough passive investment income so you don't have to work forever.
Rebalancing your investment portfolio on a periodic basis is important for risk management. People who wanted to retire in 2008, but were overweight equities in 2007 or in Feb 2020 were badly hurt.
You want to ideally have enough risk exposure to where you are comfortable losing X percent without freaking out.
To quantify your risk tolerance, I came up with Financial SEER. It is a smart and logical way to see how much you should invest in risk assets.
While some investors rebalance their portfolios frequently, many others let it slide — either because they don’t know how or lack the time to do so. However, it’s one of those essential investment tactics that’s vital to any successful portfolio and should not be left undone.
How To Rebalance Your Investment Portfolio
When you first establish an investment portfolio, you a choose certain asset allocation based on a combination of your risk tolerance, your investment goals, and even current market conditions.
For example, if might decide to put 80% of your portfolio into stocks, 15% into bonds and 5% in cash because you're a 30-year-old who loves his job and is rapidly rising in the ranks. Taking a 80% stock exposure isn't a big deal in your opinion. However, as the market conditions change, those allocations can disappear.
How? During a prolonged bull market in stocks, your stock allocation could rise to 90% or more of your portfolio, simply because your stock positions have dramatically increased in value. At the opposite end of the spectrum, during a bear market, your stock position could fall as stocks get hammered more than bonds, simply because stock prices have fallen substantially.
Rebalancing is the strategy of adjusting your asset allocation to make sure it remains consistent with your investment goals. In some cases, that means moving money from an outperforming asset class to an underperforming asset class.
But in some cases, it means allocating even more money to an outperforming asset class and cutting your losers. Goals are different from everyone.
Asset Allocation Of Stocks And Bonds By Age
Below is a conventional asset allocation model of stocks and bonds by age. There are several different asset allocation models to follow. The main framework is to be more conservative as you get older.
The Importance Of Rebalancing Your Portfolio
The biggest risk of not rebalancing your portfolio is the possibility that you’ll find yourself with too high of an allocation in one asset class at an inopportune time.
Let’s say that your portfolio is comprised 90% of stocks. All of the sudden there is a market reversal, and stocks lose 50% of their value. Because of your excessive stock allocation, the overall value of your portfolio will fall by 45% (the 90% stock allocation X the 50% loss in stocks), wiping out an unacceptably large percentage of your portfolio.
It takes almost 100% to get back to even! This is why I say that the #1 rule of financial independence is to not lose money. Once you've amassed enough capital where you see the light or never have to work again, your main focus should be capital protection.
Had you kept your stock allocation at 60%, the overall loss to your portfolio would be no more than 30% (the 60% stock allocation X the 50% loss in stocks). Still painful, but you “only” need your portfolio to recover by about 55% to get back to even, not 100%.
Your Investment Portfolio Might Be Too Conservative
On the flip side, you could be too conservative. If your stock allocation was at 30% at the start of a new bull market — one which carries stocks higher by 200% over the next 10 years — the overall increase in your portfolio would be just 60% (the 30% stock allocation X the 200% gain in stocks).
Had you kept your portfolio rebalanced, maintaining a 60% stock allocation, the overall increase in your portfolio would be 30% (your 60% stock allocation X the 50% gain in stocks).
Of course, you never know exactly how the stock market or bond market will turn out. All you can do is rebalance to the best of your risk tolerance.
Periodic rebalancing is a way of maintaining the desired level of diversification in a portfolio. Failing to do so can expose you to greater risk, whether the stock market is rising or falling.
Best Asset Class Returns
Now that you know how to rebalance your portfolio and why, take a look at the best asset class returns. Investing is not just about stocks and bonds.
Take a look at the below 20-year annualized returns by asset class (1999 – 2018). The chart shows that REITs, Gold, and Oil actually outperformed the S&P 500. In other words, you may want to invest in alternative assets as well.
My favorite investment is in real estate crowdfunding. REITs are great for broad real estate exposure, as we see in the chart above.
Investing in real estate through a company like Fundrise provides more surgical exposure to certain types of commercial real estate investments across the country. I've invested $810,000 in real estate crowdfunding to diversify my assets and earn income 100% passively. Fundrise is free to sign up and explore.
I believe there's a big opportunity to buy up heartland real estate and companies and workers migrate away from the expensive costal cities thanks to cost of living and technology.
Real estate is my favorite asset class to build wealth because it produces income, provides shelter, and is tangible.
Three Main Rebalancing Methods
There are different methods to rebalancing your investment portfolio.
1. Sell overexposed assets, buy underexposed assets. Your goal is to stick to a specific asset allocation throughout your investment time frame. If you desire a 70/30 stock/bond allocation, then you should adjust your portfolio to fit that allocation each month, quarter, half-year, or year.
2. Diversify winners. You can't lose if you lock in a gain. But sometimes, you want to sell your winners and reinvest the proceeds in search of more potential winners. It may not be a bad idea to sell a portion of one big winner and diversify into several potential winners to remove company-specific risk.
3. Invest new money into underperforming asset allocations. This is my favorite way to invest because you're always injecting new money into your portfolio and making it grow bigger. With this method you won’t be dependent on the performance of individual investment classes. Instead, you’ll direct fresh investment capital into any asset classes that fall below your portfolio allocation. For instance, if your stock position is rising in a bull market, newly invested money would be put into your bond and cash allocations, rather than into your stock position.
How Often Should You Rebalance?
The frequency of rebalancing all depends on you. I personally like to rebalance once a quarter or at least check my portfolio once a quarter. But some people like to rebalance just once a year given their extremely long time horizon.
Time. You don't have to rebalance monthly, quarterly, semi-annually or annually. But you should come up with a regular time interval to regularly do a deep dive on your portfolio. Just remember that the more frequently you rebalance, the more you pay in transaction fees and taxes. Therefore, I do like the main rebalancing method of adding new money to underperformers.
Threshold. Rebalancing at certain thresholds is about setting certain percentage levels at which you will need to reallocate. For example, you might determine that once a weighting is 5% beyond your desired asset allocation, it's time to rebalance.
You can also keep things simple and just have a three-fund portfolio for retirement as well. Often times, simplicity is the best way to go when it comes to investing.
Best Ways To Rebalance Your Portfolio
My favorite way to invest nowadays is to use a digital wealth manager like Personal Capital to automatically rebalance your portfolio based on your risk tolerance. You can simply choose your asset allocation when you begin using the service, and rebalancing will be done without having to change it. Personal Capital is the premier hybrid digital wealth advisor today.
Below is an example of a customized Personal Capital portfolio that will maintain its asset allocation each month automatically for you once you initially fund your account. Then you can automatically contribute to your portfolio on a bi-weekly or monthly basis to dollar cost average.
You can also use Personal Capital's free tools to track your investments and net worth. Below is a sample snapshot of Personal Capital's Investment Analyzer tool that shows an asset allocation breakdown. From there, you can easily make your own rebalancing decisions.
Best of luck with your investment portfolio rebalancing decisions. Remember, the key to great wealth is to invest regularly. Over a 10 year period, you will be amazed by how much you'll end up having if you stay consistent.
Once you've accumulated enough capital, please focus on capital preservation. Once you've won the game, you don't want to lose and have to start over!
You can sign up for my free newsletter here.