Do I Really Need to Rebalance?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. As investors review their year-end statements, they may be thinking, "Do I really need to rebalance?" Joining me today to answer that question and to share some rebalancing tips is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Thanks for being here.

Amy Arnott: Hi. Thanks for having me.

Dziubinski: Let's start out with the basics. What is rebalancing, and why are investors encouraged to do it?

Arnott: Rebalancing is the process of looking at your portfolio's major asset classes and how much of the portfolio is dedicated to each one, and if those percentages have drifted away from the target level that you originally set or the mix that you think is most appropriate for your time horizon and risk tolerance, then making adjustments to bring those allocations back in balance.

Dziubinski: Let's look at a portfolio that was established maybe five years ago that was 40% in U.S. stocks, 20% in international stocks, and the remainder in bonds, which is 40% in U.S. bonds. What would that portfolio look like today if it hadn't been rebalanced or touched at all during the past five years?

Arnott: If it had been--if it's been several years since you've rebalanced your portfolio, you're probably going to see the percentage allocations have drifted quite a bit. So, with the equity allocation, for example, you started out with 60% in the example that you gave. But because the equity market has done so well, with gains of 20% or more for four of the past five calendar years, that overall equity percentage would have increased to about 74%. And then, because the U.S. market has continued to perform better than international markets, you also might find that you're a bit heavy on U.S. stocks relative to international stocks. And then, within the U.S. market, although value stocks had a brief resurgence last year, growth stocks have generally continued to outperform by a pretty wide margin. So, you probably would also find that you're overweight in growth stocks versus value stocks. So, the growth side might be a logical place to look if you want to reallocate part of those assets to fixed-income holdings.

Dziubinski: Given this type of shift that could have happened, Amy, are there certain types of investors whom rebalancing is more important for? And then, of course, on the flip side, what type of investor might be able to be a little bit less concerned about rebalancing?

Arnott: If you're approaching retirement age or already in retirement, you probably want to keep a pretty close eye on your portfolio allocations and make sure they haven't drifted too far away from the target levels that you have in mind. And the reason behind that is what we've discussed before, which is sequence of returns risk, which is the risk that your portfolio goes down right before you need to start tapping into it for retirement income.

If you're a younger investor in your 20s or 30s and you have a couple of decades until retirement, you can afford to be a little bit more relaxed with rebalancing. But again, you probably want to check in every once in a while just to make sure that things haven't gotten too far away from what you intended originally, especially if you're someone who is risk averse and might tend to panic if the market has a downturn.

Dziubinski: Amy, what's a good rule of thumb when it comes to how often an investor should rebalance?

Arnott: We did some research on this last year and found that either quarterly or annual rebalancing seemed to have the best results in terms of controlling a portfolio's risk level and downside drawdown risk. Another guideline that a lot of people use is looking at a threshold strategy where whenever a major asset class moves either 5% higher or lower than your target level, then use that as a trigger for rebalancing. But really, the most important thing isn't the specific strategy for rebalancing but just something that you do on a regular basis and paying attention to your portfolio's allocations and adjusting them as needed is something that's going to help control volatility and drawdown risk.

Dziubinski: For someone who is about to engage in rebalancing, you suggest that investors start with their tax-deferred accounts like IRAs and 401(k)s. Why is that?

Arnott: The tax-deferred side is really the easiest place to rebalance because you can buy and sell without having to worry about any tax consequences like realized capital gains. So, that's definitely the best place to start with rebalancing. And then, if you need to make additional adjustments, you may need to look at taxable accounts, which can be a little bit more tricky because you may have to deal with realizing capital gains and trying to offset those with capital losses.

Dziubinski: And then, you also point out, Amy, that for retirees who are taking required minimum distributions, they can use those RMDs as a tool with rebalancing. How might that work?

Arnott: Exactly. So, when you're taking a required minimum distribution--this is a withdrawal that you're required to take as a certain percentage of your portfolio each year depending on your age, but you do have a choice as to which assets you're selling to raise cash for that distribution--it can definitely be a great opportunity to look at areas of your portfolio that are above target and use that as the first place to look when you're taking a required minimum distribution.

Dziubinski: And then, lastly, Amy, you did allude to taxable accounts. What role can they play, if any, in that rebalancing process?

Arnott: As I mentioned, taxable accounts can also play a role with rebalancing, but it does get a little bit trickier. So, one thing you can do is try to look at unrealized losses and use those to offset gains. Or if you're still making contributions to taxable accounts, you can use those--kind of steer those new monies into areas that are below your allocation target and use that as a way to rebalance as well.

Dziubinski: Amy, thank you for your time today and for these rebalancing tips. We appreciate it.

Arnott: Sure. Great to be here.

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