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Rebalancing to Keep Your Portfolio on Track

Few investors can forget the damage wreaked when the high technology bubble burst in 2000, chopping 46% from the technology-dominated NASDAQ Composite Index by the end of 2002.1 But how many have learned from the tech wreck and ensuing bear market and acted to protect their portfolio against unexpected risk? Those who have learned make sure they periodically review the balance of assets in their portfolio.

For each review, they calculate how much of their money is in stocks, bonds, and other asset classes. Then they decide whether they are comfortable with those allocations. If not, they rebalance to bring the allocations back to their intended targets. Rebalancing can be accomplished in one of two basic ways: selling investments in the asset class that exceeds the target and buying investments in the underweighted asset or using new money to increase the underweighted asset.

However, many investors dislike rebalancing because it means selling winners in favor of losers. Rebalancing can also generate transaction fees, as well as taxes on gains created by selling securities. Nonetheless, most financial professionals believe the advantages outweigh the disadvantages.

Correcting for Allocation Drift 

To appreciate how performance differences can affect an unbalanced portfolio over time, throwing it more and more out of sync with its original allocations, consider what happened to a hypothetical portfolio left unbalanced for the 20 years ended December 31, 2018 (see chart). As you can see, the original 70% allocation to U.S. stocks grew to 78%, while the other allocations shrank, reducing their intended risk reduction role in the portfolio. As always, past performance is no guarantee of future results, and asset allocation is no assurance against loss.2

Bonds haven't been as volatile as stocks over long periods, but recent history shows that they, too, can experience performance patterns that may alter asset allocation over time. Consider the divergence of the stock and bond markets in 2008 and how that affected asset allocations. While the S&P 500 lost 37% during this period, long-term U.S. government bonds gained 23%. A portfolio composed of 50% of each at the start of the year would have shifted to an allocation of 34% stocks and 66% bonds at year's end.2

Drift Can Expose a Portfolio to Greater Risk

Source: ChartSource®, DST Systems, Inc. Domestic stocks are represented by the total returns of the S&P 500 index, an unmanaged index that is generally considered representative of the U.S. stock market. Bonds are represented by the total returns of the Bloomberg Barclays U.S. Aggregate Bond index. Money markets are represented by the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index. Foreign equity is represented by the total returns of the MSCI EAFE index. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Past performance is not a guarantee of future results. © 2019, DST Systems, Inc. All rights reserved. Not responsible for any errors or omissions. (CS000128)

Seeing the Whole Picture 

If you have multiple investment accounts, determining whether to rebalance may involve several steps, beginning with a check of your overall allocation. This entails figuring how your money is divided among asset classes in each account and then across all accounts, whether in taxable brokerage, mutual fund, or tax-deferred accounts.

To gain a full appreciation of your investment strategy, go beyond stocks and bonds and calculate the percentages you have in other asset classes, such as cash and real estate. In addition, you may want to evaluate your allocations to categories within an asset class. In equities, for example, you might consider the percentages in foreign and domestic stocks. For the fixed-income portion of your portfolio, you might break your allocation into U.S. Treasuries, municipals, and corporate bonds. If you're pursuing income from bonds, you may want to know the split among short, medium, and long maturities.

How often should you rebalance? The usual answer is anytime your goals change; otherwise, at least once a year. However, to keep close tabs on your investment plan and make sure it doesn't drift far from your objectives, you may prefer to set a percentage limit of variance, say 5% on either side of your intended target, that would trigger a review and possible rebalancing.

Money-Saving Ideas

Consider these possibilities for reducing transaction costs and taxable gains when rebalancing:
  • Make as many changes as possible in an account that charges low trading fees -- for example, a 401(k) account, which may offer free transactions, or a low-cost brokerage account.
  • To avoid tax liability, rebalance using new money instead of moving existing money around. Or limit your immediate tax liability by making changes when possible in a tax-deferred account like a 401(k) or an individual retirement account (IRA).
  • If you're looking for new money to help rebalance your portfolio, consider using lump-sum payments such as a bonus or tax refund.

1Source: DST Systems, Inc. For the period December 29, 2000, to December 31, 2002. The NASDAQ Composite Index is an unmanaged index. Individuals cannot invest directly in any index.

2Source: DST Systems, Inc. Stocks are represented by the S&P 500 index, bonds by long-term U.S Government bonds. Investors cannot invest directly in any index. Past performance does not guarantee future results.

Content is provided by Wealth Management Systems Inc. as a service to Wells Fargo. Copyright © 2019, Wealth Management Systems Inc. All rights reserved.