Portfolio rebalancing: Helping to keep your investments on track

When you begin working with a financial advisor on an investment strategy, you discuss your goals and risk tolerance before populating your portfolio with an asset mix that aligns with your strategy. What happens from there is predictably unpredictable. Markets rise and fall, and your mix of bonds, stocks and cash can change.

That's why you and your financial advisor need to periodically do a checkup to see if your investment mix is meeting the goals you've set for yourself. This often leads to portfolio rebalancing, which is how you maintain your intended asset mix and stay on track toward your goals.

Rebalancing is the process of buying and selling securities to restore the mix of investments in your portfolio to their original target allocations. It also serves as a systematic way to take the emotion out of investing.

Rebalancing is usually necessary on a periodic basis, such as annually, because diverse investment securities can change in price over time, requiring you to make adjustments so that you'll have the best chance for success.

Rebalancing a portfolio realigns the holdings back to their original target mix of assets. Over time, you generally can expect some investments to grow as a percentage of your portfolio and others to decline. Rebalancing may require you to sell shares of the investments that grew and buy shares of the investments that declined.

Perhaps the most important reason for rebalancing is to adjust the portfolio holdings so they continue to reflect your risk tolerance. For example, a portfolio that becomes too heavily allocated toward one particular investment or asset class can increase or decrease the portfolio's risk. Check your risk tolerance profile periodically, too, because your goals or comfort level can change over time.

Rebalancing a portfolio can impact a portfolio's long-term performance. This is because it effectively buys shares in the underperforming classes and sells shares of well-performing assets (i.e., buying low and selling high), which may improve performance over time.

Say, hypothetically, you and your financial advisor establish a preferred asset allocation that reflects your risk tolerance, with 50% U.S. stocks, 30% bonds and 20% international stocks. This asset mix provides a medium level of risk when you have at least 10 years until you reach your investment goal, such as retirement.

Five years later, your asset values have likely shifted. Your allocation may now be 59% U.S. stocks, 24% bonds and 17% international stocks. This portfolio allocation may be riskier than, and no longer consistent with, your original allocation.

This is the primary reason to rebalance your portfolio. You want to maintain an asset mix that suits your risk tolerance and long-term goals. You and your financial advisor should regularly review your allocations, reevaluate your risk level and make the appropriate changes when need be.

Under normal market conditions, stocks grow faster than bonds. This naturally causes a balanced portfolio of stocks and bonds to fall out of balance. In other words, your stock allocation may be higher and your bond allocation may be lower than the original asset mix over a certain period of time, such as one year.

But on average, every three to five years, stocks enter a bear market, which is defined as a 20% decline from the most recent high. In this environment, bonds may remain stable or even gain value. However, like the markets experienced in 2022, both stocks and bonds can fall in price.

The key takeaway here is that market conditions impact your investments. This is why rebalancing plays an important role in smart portfolio management.

You can rebalance your portfolio either manually or automatically. More specifically, rebalancing can be done on a calendar, percentage or strategic basis.

You or your financial advisor place the necessary trades (buying or selling investments) to return your allocation percentages back to their original targets.

Most commonly available with 401(k) plans or "robo-advisor" accounts, you can select an automated account feature to keep your asset mix in balance with your most recent allocation settings.

You reset your portfolio based on a specified periodic basis, such as quarterly or annually. You might use a specific day of the year, such as your birthday or the first business day of the year.

With this method, you wait to rebalance until allocation percentages reach a specified limit range. For example, if the target stock allocation is 60% and the specified limit range is 5%, you don't rebalance unless the stock allocation reaches 5% under or over the target, or 55% or 65% of the portfolio respectively.

With an active management approach, you may time buying or selling investments in your portfolio based on market conditions. For example, you may choose to buy or sell an investment security when market prices swing in one direction or the other.

While there's no set time frame for how often you should rebalance your portfolio, the minimum frequency for reviewing your account and checking in with your financial advisor is once a year. You might not rebalance every year, but your portfolio can often benefit from an objective annual review.

Rebalancing your investment portfolio is generally a good idea, but it can come with potential risks and consequences. For example, if you rebalance a portfolio of investments in a taxable brokerage account, selling investment securities could generate capital gains taxes.

And if you depend on your investment accounts for income purposes, you need to consider which investments to sell. You must assess whether your allocation percentages reflect your proximity to retirement and your current risk tolerance.

So, before rebalancing, consider the pros and cons.

• Risk management. Rebalancing a portfolio keeps your investments in line with your risk tolerance.

• Tweaking performance. Rebalancing effectively sells the "winners" and buys the "losers" in your portfolio, which is generally a good way to help your account value grow over time while reducing market risk.

• Tax consequences. If you sell an investment in a taxable brokerage account and your investment has a profit, the gains may be taxed up to 20%, depending on your tax bracket.

• Fees. While most brokerages and other financial institutions offer commission-free trading on many investments, some security types, such as certain mutual funds, may charge redemption fees for selling shares.

Rebalancing is just one aspect of the portfolio management process, which is one piece of a financial strategy. When you rebalance your portfolio, consider the benefits and risks. For example, rebalancing is generally a good idea for maintaining a planned risk profile for your portfolio; however, selling investments at the wrong time or in the wrong account type may increase risk or generate tax consequences.

Whether you're building a portfolio for retirement or you're already retired and using your investments for income, consider your options before rebalancing.

Connect with a financial advisor to discuss your retirement strategy, including navigating different investment options and rebalancing portfolios.