How Rebalancing Your Portfolio Can Help Mitigate Market Volatility

Over time, especially during a sustained market run-up or in the aftermath of a major market correction, your portfolio’s asset allocation can gradually but dramatically shift from its intended target. This can result in a potentially harmful imbalance in which you may unwittingly take on too much risk after market highs and too little risk during market lows—the exact opposite of what you had envisioned.

When Should You Rebalance?

There’s no particular advantage to rebalancing at a market high versus a market low; each has its particular benefits. Rebalancing when the market is high can reduce the impact of the next correction on your savings, and rebalancing after a correction provides an opportunity to harvest some tax losses. Most importantly, rebalancing is about being disciplined and sticking closely to your financial plan by not straying too far from your portfolio’s intended target allocation.

Here is a hypothetical example: $100,000 invested 60% in stocks and 40% in bonds in March 2009, at the end of the financial crisis, would have been worth more than $356,000 by January 2021. However, the stocks (worth $309,694) would have increased in value so much more than the bonds (worth $46,518) that the original moderate portfolio allocation of 60% stocks, 40% bonds would have become a much more aggressive allocation of 87% stocks and 13% bonds. ¹

Eleven years into the longest bull market in U.S. history is not when you want to be assuming far more investment risk than you intended. This same principle holds true in reverse for bear markets. After a major market correction, a moderate 60/40 allocation could quickly drift to a more conservative 45/55 allocation, taking on significantly less investment risk (and corresponding growth opportunity) at a time when the market is poised for recovery.

Tax-Smart Rebalancing Strategies

Rebalancing involves buying and selling investments, so it needs to be approached thoughtfully to help minimize transaction costs and avoid triggering any sizable long-term capital gains taxes. There are three common strategies that are used to rebalance:

1. Rebalance holistically. Rather than rebalancing each of your portfolios separately, this approach involves looking at all of your taxable and tax-deferred portfolios as a whole. Even if one portfolio is out of balance, your overall allocation may still be appropriate.
2. Sweep rather than reinvest. Most people choose to have their dividends and interest reinvested into the purchase of additional shares. However, this can hasten an allocation imbalance in your portfolio. Consider sweeping your dividends and interest into a money market fund. When it is time to rebalance, you’ll have cash available to use for additional investment purchases instead of having to sell some of your holdings and thereby triggering capital gains.
3. Gift highly appreciated stock. If you’re charitably inclined, one particularly effective approach to rebalancing is to gift shares of your highly appreciated stock to a registered 501(c)(3) charity. This approach avoids triggering any capital gains and gives you a charitable deduction on your taxes.

Of course, as with any tax-related investment decisions, you should always consult with your tax attorney to assess the potential impact before undertaking any rebalancing transactions.

Rebalancing is a strategy to help manage your exposure to risk. Experts recommend rebalancing your portfolio at least once a year, or whenever there is a major change in your financial goals, needs, or circumstances. Talk with your financial advisor to review your actual versus target allocations and decide on a rebalancing strategy that fits your needs.

Key Takeaways

Periodic rebalancing is essential to maintaining the appropriate level of investment risk in your portfolio.

Different asset classes appreciate or depreciate more quickly than others, so over time your overall asset allocation can drift dramatically from your intended target.

There are a variety of rebalancing strategies to consider. Talk to your financial advisor to determine the strategies that are best for your situation.

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Lynzie Wolters, ChFC® RICP® is a Registered Representative offering securities through NYLIFE Securities LLC, Member FINRA/SIPC, a Licensed Insurance Agency, and a Financial Adviser offering investment advisory services through Eagle Strategies. Lynzie Wolters, ChFC® RICP® is also an agent licensed to sell insurance through New York Life Insurance Company and may be licensed to sell insurance through various other independent unaffiliated insurance companies.
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