How to Rebalance Your Investment Portfolio Before 2024

Key Takeaways

• The main reason for rebalancing is to control risk, not necessarily to improve returns.
• Take a strategic approach to your asset allocation, and the main factors you would want to look at would be your time horizon and your specific financial goals. In addition to the overall mix of stocks, bonds, and cash, also look at U.S. versus international and value versus growth.
• A tax-deferred account like a 401(k) or an IRA is the best place to start because you can buy and sell within the same account without realizing any capital gains that you’ll have to pay taxes on.
• If you are looking to raise some money to help support your retirement spending or to cover a required minimum distribution, it makes sense to be strategic about where you’re selling from, and you don’t have to sell across all of your holdings evenly or even across all of your accounts.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Investors frequently review their portfolios this time of year in an effort to restore positions that may be out of whack or to take advantage of what they see as new opportunities. Here with me to share some tips about how to rebalance an investment portfolio for the new year is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Amy, nice to see you.

Amy Arnott: Nice to see you, too. Thanks for having me.

Who Should Rebalance Their Portfolios?

Dziubinski: Let’s start with the basics. Is rebalancing annually a must-do for investors or is rebalancing more important maybe for some investors than others?

Arnott: The main reason for rebalancing is to control risk, not necessarily to improve returns. So, it’s a good idea for most people, but I would say it gets more important as you get older. If you’re a young investor, you’re saving for retirement that’s a couple of decades down the road, you might want to take more of a hands-off approach to rebalancing and check in occasionally, but don’t worry about making portfolio changes unless your asset mix changes significantly from your target levels. As you get older, you have a much smaller margin of safety as you are leading up to retirement and then actually in retirement. So, in that case, it’s definitely important to rebalance on a regular schedule and make sure your portfolio is on track.

How to Reexamine Your Asset Allocation

Dziubinski: Let’s start at the top, which is really the investor’s asset allocation among those two broad asset classes of stocks and bonds. What factors should investors be considering when reexamining that mix, particularly at the end of this year?

Arnott: I think the most important thing is to take a strategic approach to your asset allocation, and the main factors you would want to look at would be your time horizon and your specific financial goals. If those two things haven’t changed, you probably don’t need to make any changes to your target asset allocation. But if something has changed in your life, maybe you are approaching retirement, so you want to pull back on equity exposure, or if you’re saving for a child’s college education, you probably want to be shifting almost everything into cash and bonds by the time your child reaches high school age. So, those are a couple of examples of when you might want to shift that stock and bond mix.

Subasset Classes

Dziubinski: How important is it when it comes to rebalancing to go beyond those two broad asset classes? How far down into subasset classes do investors need to delve?

Arnott: I think it makes sense to go at least one level down. So, in addition to the overall mix of stocks, bonds, and cash, I would also look at U.S. versus international and then value versus growth. And depending on how long it’s been since you last rebalanced the portfolio, you might find that some of those subasset mixes need to be tweaked a bit. So, if it’s been, say, five years since you last rebalanced the portfolio, you might find that you’re actually pretty significantly overweight in U.S. stocks versus international and also growth stocks versus value stocks. If it’s only been a year or so since you last rebalanced, you’re probably not that far away from your target levels. But again, you might still be a bit overweight on the U.S. side because domestic stocks have outperformed this year and also in growth stocks as growth stocks have returned to the fore so far in 2023.

Tax-Deferred Accounts and IRAs

Dziubinski: What strategic considerations are there when an investor finds that, OK, my asset mix is a little out of whack, or my subasset mix isn’t exactly where I want it to be given my goals and time horizon? Where should the pruning and the changes happen? Is it always in tax-deferred accounts? How should an investor think about that?

Arnott: A tax-deferred account like a 401(k) or an IRA is definitely the best place to start. And the reason behind that is you can buy and sell within the same account without realizing any capital gains that you’ll have to pay taxes on. So, if you can do all or most of your rebalancing on the tax-deferred side to get the overall portfolio in balance, that’s really ideal. Things get a little bit trickier with taxable accounts because you have to weigh the trade-offs of the benefits of rebalancing in reducing risk, as I mentioned before, versus the potential tax impact of selling assets that have appreciated.

Should Investors Be Moving Some of Their Bond Allocations to Cash?

Dziubinski: Let’s talk a little bit about bonds. Given the sizable yields that cash investments offer today, should investors consider moving some of their bond allocations to cash? Why or why not?

Arnott: That’s a great question and I think it’s a question that a lot of investors have been thinking about recently. So, now that you can get more than a 5% yield on cash without you’re not taking any interest-rate risk, you’re not taking any credit risk, you can still stay ahead of inflation. So, it does sound pretty attractive to a lot of people, and we have seen a pretty large movement of assets into money market funds than any other cash type of assets over the past year or so. But I would keep in mind that even at times when cash yields are very attractive, there are still some risks involved. One of them is reinvestment risk. So, if and when yields start going down again, you’re going to be reinvesting your cash at lower and lower rates.

Another thing to consider is the opportunity cost. So, I actually just wrote an article about this and even if you buy into cash at times when the yields look very attractive like they do now, I looked at subsequent returns over different periods—three years, five years, and 10 years—and found that the majority of the time cash still falls behind other types of assets like stocks and intermediate or long-term bonds. So, cash can be a great place to be for short-term savings or an emergency fund, something like that, but still not the best place to build long-term wealth.

Bonds and ‘Higher for Longer’ Interest Rates

Dziubinski: In that bond sleeve, let’s stay on that topic, what should an investor’s duration look like particularly if we are entering a “higher for longer” interest-rate environment?

Arnott: I’m kind of a fan of a middle-of-the-road approach to bond exposure. I wouldn’t overdo it on cash as I just mentioned, but I wouldn’t overdo it on long-term bonds either. We still have this situation where the yield curve is inverted. So, you’re actually getting better yields in short-term and intermediate-term bonds, and you’re not really getting paid to take on interest-rate risk, in my opinion, at the long end of the yield curve. So, I think intermediate-term bonds make sense as core holdings for a lot of people or short-term bonds if your time horizon is shorter.

Retirement Spending and RMDs

Dziubinski: Are there things that retirees who are already tapping into those portfolios for retirement spending should be thinking about as they are reviewing their portfolios at year-end?

Arnott: If you are looking to raise some money to help support your retirement spending or to cover a required minimum distribution, I think it definitely makes sense to be strategic about where you’re selling from, and you don’t have to sell across all of your holdings evenly or even across all of your accounts. So, I would take a very targeted approach and try to sell from asset classes that are out of balance or above the target for your asset mix, and by doing that you can help bring your portfolio back into balance.

How Much ‘Fun’ Money Is Too Much?

Dziubinski: Amy, some investors maintain what they might call a small bucket of fun money, or money that they use to maybe scratch a particular itch they may have that’s maybe more of a bet than say a long-term investment that’s a part of their retirement plan, let’s say. How can investors rightsize that fun money position within their portfolio? How much fun is too much fun from a portfolio allocation standpoint?

Arnott: A lot of people use 5% of assets as a rough guideline that you wouldn’t want to go above that level, but I think you really want to think through not just the potential upside of a fun investment but what would happen if it actually went to zero. Would that create big problems for you in terms of meeting your financial goals? And if so, it’s probably not a great idea.

Dziubinski: Right. Then lastly, Amy, what are an example or two maybe of fun money for investors today?

Arnott: I think one interesting area would be small-cap stocks. As you know, the equity gains so far this year have been driven really in large part by the “Magnificent Seven” group of Big Tech stocks like Amazon AMZN, Alphabet GOOGL, Nvidia NVDA, et cetera. So, those seven stocks as a group account for about two thirds of the stock market’s returns so far this year. So, with those stocks getting so much attention and higher valuations, small-cap stocks I think have been kind of neglected, and as a result, a lot of them are trading at pretty attractive valuations. So, as a group, small-cap stocks are trading at roughly a 24% discount to our analysts’ fair value estimates.

Stock Picks

Dziubinski: Amy, I know I queued up that last question as lastly, but I do have one more for you. Are there any particular stocks in particular that you would find attractive today according to Morningstar’s measures?

Arnott: I do look at Morningstar’s equity research, and when I do buy individual stocks, I like to buy stocks with wide moats or a sustainable competitive advantage that are trading at a discount to what our analysts estimate for their fair value. And I think there are some interesting opportunities there. So, stocks like Anheuser-Busch BUD, Campbell Soup CPB, Zimmer Biomet ZBH, things like that. Those are just a couple of examples. But if you do buy individual stocks or undervalued areas, I would definitely keep that, as we discussed, to a small percentage of your portfolio and really focus most of your attention on making sure your asset mix makes sense for your situation and doing more of the routine tasks like rebalancing to make sure things are on track.

Dziubinski: Makes a lot of sense. Thank you for your time today, Amy.

Arnott: Sure. Thanks for having me.

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

Watch “5 Surprising Investments That Shouldn’t Be Long-Term Core Holdings” for more from Amy Arnott.