For mutual fund investors, taxes are inevitable. Even if you’re a long-term buy...
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To use a very simple example, assume that your desired portfolio allocation is 70% stocks and 30% bonds. Let’s also assume that you’ve already achieved your desired allocation. What happens if, say, stocks vastly outperform bonds? In this case, your allocation will get skewed much more in favor of stocks. If the value of your stocks increases at a significantly higher rate than your bond holdings that 70/30 allocation could become 80/20 or even 90/10 (you get the idea).
When you developed your portfolio, you set a specific allocation because it’s the one most likely to meet your investment goals and risk tolerance. This means you need to periodically rebalance the portfolio to ensure that the original allocation is maintained.
In the above example, you may need to purchase more bonds to regain your desired portfolio allocation. If you don’t, your portfolio will be skewed toward stocks more heavily than you originally intended. This may not be bad during bull markets but if stocks correct lower you will be exposed to all sorts of risks.
Against this backdrop, you now know the two main goals of portfolio rebalancing: (1) targeting risk and return characteristics and (2) controlling risks.
Want to know how to figure out your target asset allocation? Click here.
No successful value investor can get through life without a proven risk management strategy. Portfolio rebalancing offers just that and gives you a very clear framework by which to achieve it.
Rebalancing also isn’t nearly as complicated as some are led to believe. As Vanguard notes in its research, “there is no optimal frequency or threshold when selecting a rebalancing strategy.” In other words, investors have plenty of flexibility when it comes to rebalancing. This flexibility extends to frequency, asset allocation and asset selection.
Learn about other portfolio management concepts here.
Investors who are rebalancing their portfolio have to conduct more trades to recapture their desired asset allocation. More trades mean more fees, including purchase and redemption costs. In addition to fees, portfolio rebalancing is a very active process, which means time and manpower costs associated with research and asset selection.
At the same time, the need to rebalance may force some investors to leave profit on the table because they are proactively managing their asset allocation. In the stocks/bonds example above, an investor may feel the need to rebalance even when stocks still have more runway to continue higher. So, in a sense, they are leaving earnings on the table.
Investors who rebalance within taxable investment accounts or vehicles may also incur capital gains taxes when they sell a portion of their assets so they can allocate the funds elsewhere. Those huge stock gains you enjoyed in the previous illustrations can carry a hefty tax payout unless sheltered in a tax-free account.
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