Spring, Renewal, and the importance of Regular Portfolio Rebalancing

Melissa A. Seamon, CFP®

Senior Financial Advisor

Did you know that according to the Cleveland Clinic, the mental health benefits of “Spring Cleaning”—the annual practice that prioritizes decluttering and organizing one's living space—can have positive psychological effects? It appears that the process of cleaning can actually reduce stress, improve mood, and increase productivity. It can also foster a sense of accomplishment and create a more relaxing environment. And donating or recycling unwanted items can promote feelings of generosity and help others in need.

So, while most of us are busy Marie Kondo-ing our closets for a dopamine boost, it's also the perfect time to dust our finances thoroughly. After all, who doesn't want to tidy up their wealth just as much as they do their sock drawer? The best place to start is with your portfolio.

Is Your Portfolio Out of Alignment?

In the last few years, we have seen extreme market swings to the upside and the downside. In either case, extended market moves can knock your target asset allocation out of alignment, exposing your investment portfolio to more significant risks.

A strong market can bring great returns, but it can also increase your risk if your asset allocation no longer reflects your investment profile. The same goes for a down market, which could make it more difficult for your investments to recover when the market turns around.

That's why it's important to rebalance your portfolio after significant movements in the market.

You Choose an Asset Allocation for a Reason

When investing for the long term, it is essential to allocate your funds according to your target asset allocation. Your asset allocation is your chosen mix of assets based on the amount of risk you are willing to take to generate a certain level of returns. For example, if your risk profile is conservative, it means you are willing to accept lower returns because you don't want to take a lot of risk in your portfolio. Depending on how close you are to retirement, that might translate into a 40/60 asset mix between stocks and bonds. If you are willing to assume more risk to generate higher returns, your asset allocation might look more like 70/30 with a heavier weighting in stocks.

A Misaligned Asset Allocation Increases Your Risk

Within each asset class, there are different levels of risk/return. For instance, if you allocate 60% of your portfolio to stocks, you may invest equally among a more conservative blue-chip stock fund, an aggressive small-cap stock fund, and an international stock fund. Let's say the stock market performs well, and small-cap stocks outperform all other classes of stocks. You look at your stock portfolio, and instead of being equally weighted among the three funds, your small-cap fund has grown to comprise 50% of your stock portfolio.

By virtue of small-cap stocks' strong performance, your stock portfolio is now exposed to more risk because small-cap stocks tend to be much more volatile than other stock classes. If you want to return your portfolio to the risk-return profile you started with, you must rebalance your asset allocation.

Suppose you are a conservative investor with a 40/60 stocks/bonds allocation, and the stock market rises by 30%. That's great for your portfolio value, but your allocation has changed to 60/40, which introduces more risk than you are willing to assume. If you don't rebalance your portfolio back to 40/60, you will be outside your risk comfort level, and in the next stock market downturn, your portfolio value could suffer a much more significant decline.

Rebalancing Keeps Your Asset Allocation on Target

When you rebalance your portfolio, you realign your assets back to your target allocation to maintain your desired risk-return profile. At its simplest, you sell securities that have become overpriced and buy securities that have declined in value. That virtually guarantees you are selling high and buying low, which is a key to solid investment performance. For a conservative 40/60 allocation, it might mean selling a portion of your stock funds and buying additional shares of your bond funds. It would be best to rebalance your portfolio once every 12 to 18 months or following a significant market move to prevent unwanted risk from seeping into your portfolio.

Spring is the Perfect Time to Renew and Rebalance Your Investment Portfolio for Better Returns

Like a garden that needs pruning, your investment portfolio can benefit from regular maintenance, too. Review your asset allocation and ensure it aligns with your risk tolerance and financial goals. A common misconception among numerous investors is that an investment's strong past performance guarantees similar future results. Regrettably, an investment's historical performance does not necessarily predict its future success. By closely monitoring your portfolio and making timely adjustments, you can optimize your returns and minimize your risks, ultimately nurturing your wealth like a well-tended garden.

If your portfolio is in need of a rebalance, we encourage you to schedule a call to learn more about our services and to see if we could be a good match. We best serve clients looking for exceptional client service, who value a long-term partnership, and have a minimum of $500,000 in investable assets.

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Resources:

Investopedia - Rebalancing: What it is and Why it's Important https://www.investopedia.com/terms/r/rebalancing.asp
Forbes - How to Rebalance Your Portfolio: A Step-by-Step Guide https://www.forbes.com/sites/financialfinesse/2021/06/13/how-to-rebalance-your-portfolio-a-step-by-step-guide/
Morningstar - The Art and Science of Portfolio Rebalancing https://www.morningstar.com/articles/1002817/the-art-and-science-of-portfolio-rebalancing
Fidelity - The Importance of Rebalancing Your Portfolio https://www.fidelity.com/learning-center/investment-products/mutual-funds/portfolio-rebalancing
Vanguard - Best Practices for Portfolio Rebalancing https://www.vanguard.com/pdf/ISGPORE.pdf
Charles Schwab - How to Rebalance Your Portfolio https://www.schwab.com/resource-center/insights/content/how-to-rebalance-your-portfolio
NerdWallet - Why and How to Rebalance Your Investment Portfolio https://www.nerdwallet.com/article/investing/rebalance-portfolio
The Balance - How to Rebalance Your Investment Portfolio and Manage Risk https://www.thebalance.com/how-to-rebalance-your-investment-portfolio-357400
Kiplinger - The Importance of Rebalancing Your Portfolio https://www.kiplinger.com/article/investing/t023-c032-s014-the-importance-of-rebalancing-your-portfolio.html
The Motley Fool - How to Rebalance Your Portfolio and Why It Matters https://www.fool.com/investing/how-to-invest/beginning/how-to-rebalance-your-portfolio.aspx