Rebalancing: What You Need to Know

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. A portfolio that was 60% stocks and 40% bonds 10 years ago would be 80% stocks and 20% bonds today. Joining me to discuss how to know if rebalancing is in order for your portfolio is Christine Benz. Christine's Morningstar's director of personal finance.

Thanks for being here, Christine.

Christine Benz: Susan. It's great to be here. Dziubinski: It is great to be here in person. So, before we get into the nitty-gritty of rebalancing, let's talk a little bit about: Why do it in the first place? What's the payoff?

Benz: Well, there really isn't a natural return payoff with rebalancing because when you think about it, you're trimming things that have appreciated--that's usually stocks for most investors. What we know is that, over long periods of time, stocks do outperform other asset classes. So the main benefit from rebalancing comes in the realm of volatility reduction--taking risk out of your portfolio. And that gets more important as we get close to our retirement date, or whatever our goal date is for our money. Rebalancing can be particularly powerful for people who are approaching retirement, where you naturally do want to reduce risk in your portfolio. You don't want to have the risk of your retirement date arrives, and you're having to draw upon a portfolio that has just suffered a big decline.

There is also a benefit in my mind to retirees from rebalancing in that they're able to harvest their cash flows by selling appreciated positions. Now a lot of retirees naturally want to try to live off of whatever income their portfolio kicks off. That might be part of the equation for many retirees, but given how low yields are today and how low they remain, I think rebalancing is a natural way to source cash flows and take risk out of the portfolio on an ongoing basis.

Dziubinski: Then, how do you know that it's time to rebalance?

Benz: Well, I think you would want to take a look at your baseline asset allocation in your portfolio and compare that to some type of a target. At this point, a lot of people might say, "Well, I don't have a target, what should I be comparing it to?" And here I think target-date funds can be a good guide if you're looking at your retirement portfolio and trying to decide if it's time to trim back on stocks after their long-running rally. Well, compare your portfolio's asset-allocation exposure to that of a good target-date fund geared toward someone in your same age band with your same retirement date. I've also often recommended Morningstar's Lifetime Allocation Indexes. They come in aggressive, moderate, and conservative flavors. That's another benchmark that you can use for gauging your baseline asset-class exposure. And that really is the main thing you should be focusing on when you are trying to decide whether it's time to rebalance.

Dziubinski: How far off should your allocation be before you say, "Ah, now is really the time to rebalance"?

Benz: It's a good question. I would say take a good look at your portfolio's asset class exposures once a year at a minimum. And if you see divergences in the major asset classes of 5 percentage points, certainly 10 percentage points, that's your signal that it's time to rebalance. And I would also say life stage is important here. Because as you're younger and wanting to maintain a stock-heavy portfolio, rebalancing isn't as mission critical. But once you're in your 50s, 60s, getting close to that retirement date, that's when it's more crucial to take a look at those asset class exposures and just make sure that you're not taking too much risk in your portfolio.

Dziubinski: Besides your overall asset allocation, what other types of things should you be looking at--market capitalization? Should you be looking at investment style? What are the other things to look at?

Benz: Yes, I would say those are worthwhile things to look at. And you might also look at your portfolio's geographic exposure within your equity allocation--your U.S. versus foreign stock allocations, I think are important. But take a look at how your portfolio stacks up from the style-box perspective, from the market-cap perspective, perhaps relative to a total stock market index fund as kind of a baseline. And you can find that information on Morningstar.com. I do think that there's potential power in combining that asset class rebalancing with some of the investment-style rebalancing. So if you decide that your portfolio is too equity-heavy, well, given that we have had a fairly long-running rally in growth stocks, mid- and large-cap growth stocks, potentially start your trimming in those areas. I think that's an important secondary set of considerations.

Dziubinski: And then lastly, Christine, what about taxes in rebalancing? Do you have to pay attention to what accounts you're rebalancing in so you aren't triggering too many taxes? What are some strategies that are more tax-efficient to pursue when you're rebalancing?

Benz: Yeah, it's such an important question, Susan. And you're right that rebalancing can trigger a tax bill if you're focusing on your taxable accounts because it typically involves selling appreciated positions where, if it is a taxable account, you're going to owe capital gains tax on them. So, you should focus your rebalancing efforts on your tax-sheltered accounts, whether traditional tax-deferred or Roth accounts, where you're not going to be paying taxes to do that repositioning. If you have a lot of taxable assets, you may need to do repositioning there, but I would put them second in the queue. And also you can be a little bit tax-sensitive if you decide you need to do some rebalancing there. You can potentially add, if you're still adding to your accounts, you can potentially add to those underweight positions to see if you can't move the needle that way. Or if you happen to have losing positions in your portfolio that you can use to offset the winning positions that you're scaling back on--that's another strategy. But ideally, start your rebalancing efforts and potentially even finish them by focusing on your tax-sheltered accounts.

Dziubinski: Got it. Well, Christine, thank you so much for your tips on rebalancing today. Nice to see you.

Benz: Good to see you too, Susan.

Dziubinski: Take care.

Benz: Thank you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.