How (and Why) to Rebalance Your Portfolio

Rebalancing is routine for the wealthy. The wealthy understand the importance of asset allocation and when the desired proportions get out of alignment, they adjust or rebalance their portfolio. There are a few tricks to rebalancing that can enhance your returns and make sure you keep more money in your pocket.

After you have the asset allocation you desire, you want your portfolio to stay as close to that allocation as possible. The best way to do that is to rebalance. But how often should you rebalance and what should you sell?

What should you sell?

First and foremost, the reason your portfolio is outside your allocation is because a specific asset class has outperformed or underperformed the other asset classes.

Example: Jacob has a target asset allocation of 70/30 stocks to bonds in the beginning of 2014. At the end of 2014 stocks have outperformed bonds and thereby Jacob's 70/30 stocks to bonds allocation now looks something like 80/20 stocks to bonds.

To rebalance Jacob's portfolio back to the 70/30 proportion he must either buy more bonds or sell stock. Jacob can buy more bonds through his monthly contribution (dollar-cost averaging) or with some extra cash. But, the most popular way to rebalance is tax-loss harvesting, selling the assets with losses.

Tax-loss harvesting is an effective strategy to rebalance your portfolio and limit your tax liability. Since you are selling the assets with a loss you can reduce your capital gains for the year. If the losses exceed your capital gains for the year then you can offset ordinary income by a maximum of $3,000.

Using the same example above, Jacob could sell the stock portions of his portfolio that are losing money or sell the worst performing bonds. Let's say Jacob chose to sell a bond fund that lost him $1,000. His income in 2017 is $50,000 and his tax bracket is 35%. Therefore Jacob has just reduced his taxable income to $49,000 ($50,000-$1,000) and saved $350 in tax liability (35%*$1,000). Instead of having the initial loss of $1,000 he has a $650 loss after accounting for the tax savings. Today, there is a max of $3,000 in tax-loss harvesting you can use to offset ordinary income in one year, but you can carry any excess losses over to the following tax years.

Tax-loss harvesting is also effective when offsetting the tax responsibility of gains in your portfolio. Jacob has gains in his portfolio from the rise in stock prices. He has a $5,000 gain in a small cap index fund, which has him out of his target proportion. He sells some of the stock and takes a $3,000 gain. With the loss of the $1,000 from bonds he sold his new tax liability is only $2,000 ($3,000-$1,000) instead of $3,000.

As of today there is no limit to how much a loss can offset a gain in your portfolio. You can use a loss to offset a gain so long as you do not repurchase the stock/bond within 30 days (wash sale rule). In other words, Jacob cannot buy the bond fund or one that is "substantially identical" for 30 days after the sale to ensure he can offset his gains.

The tax-loss harvesting strategy mentioned above, utilized correctly, will increase your portfolio returns but, it cannot be used in a tax deferred account like a 401k or IRA.

How often should you rebalance?

If you buy a stock/bond and sell it within 12 months you will be charged a short term capital gains tax, which is taxed higher than ordinary income or long term capital gains. Therefore, rebalancing may be most effective if you had a large short term capital gain (tax-loss harvesting), although I don't condone or recommend trading. The other, and more important time to rebalance, is when your asset allocation is out of proportion. Remember from a previous post, asset allocation is the single most important factor in determining market returns. When your proportions are out of balance you may be taking on significantly more risk than you had originally planned.

According to Burton Malkiel, you should rebalance your portfolio yearly if in a taxable account (to avoid short term capital gains tax) and quarterly if in a tax deferred account. For a tax deferred account you can also set a "trigger" to rebalance every time your portfolio gets to far from your preferred asset allocation.

Yes, some of this can be confusing and the rules are constantly changing. Use this as a guideline to understand the principle behind rebalancing and then read the most up-to-date information or speak with a good tax accountant because rebalancing, done correctly, will increase your returns.

Let's recap;

• Think about reducing your tax liability when rebalancing by utilizing the tax-loss harvesting strategy.
• Tax-loss harvesting isn't available in a 401k or IRA.
• For a taxable account, rebalance once a year to avoid short term capital gains.
• For a tax deferred account, rebalance quarterly or whenever your asset proportions stray from your preferred asset allocation.
• Utilize new technology to assist you with tax-loss harvesting