Rebalancing Investments: Why, When, & How to Avoid High Fees

Getting over the fear of investing is a hurdle that everyone needs to surpass.

Once you make that leap, it really can be as simple as passively investing in a few different index funds or ETF’s and calling it a day.

But even then, there is a maintenance tactic that might be a little scary to some. Today, I’d like to help you get over that fear.

The tactic I’m talking about is “Rebalancing” your investment allocation.

Here are a few examples of why you need to rebalance when investing, whether in a retirement account or otherwise…

According to Kiplinger, if you had

“60% in U.S. stocks (as measured by the S&P 500) and 40% in bonds (as measured by Barclay’s U.S. Aggregate Bond index) before the bear market started in October 2007. By the end of the bear market, the ratio would have flipped to 38% stocks and 62% bonds, just because of changes in market values.”

In another example,

“Had you invested $40,000 in the average U.S. government bond fund five years ago, and $60,000 in the average large-company stock fund. By the end of 2013, you’d have $47,476 in your bond fund, and $131,934 in your stock fund — or about 26% in bonds and 74% in stocks.”

rebalancing investmentsThat’s right. Just by the market doing its thing, your perfect target allocation quickly can get jacked up.

It might seem counter-intuitive to trade out of an investment that is doing well into one that is not doing quite as well or even poorly. However, as with these examples, without reallocation, you can stray far from your investment goals and open yourself up to considerably more risk.

Both examples show what could happen if you are investing in stocks and bonds. But, what if you’re a risk-friendly 20, 30, or 40-something investor with a long investing time-table in front of you, and as such, you’re already 100% in stocks?

First of all, good job. You’re wise beyond your years for not being risk-averse in your young age.

Second, you’d be wise to have a little bit of diversity in your portfolio beyond just one index fund or ETF, like VTI (the Vanguard Total Stock Market ETF). Here’s the thing with VTI – it’s allocation is 100% to U.S. stocks. What if the U.S. stock market tanks and has a significantly long slump, while the rest of the world is humming along? Mixing in some international, emerging market, small cap, and REIT’s would have led to a more diversified portfolio and protection from big downturns and extended slumps.

Diversification is good and provides protection. Re-balancing that diversification takes it a step further.

As with a stock/bond split, when you diversify, your balance can get a little out of whack and you need to re-allocate.

The Cost of Rebalancing Investments

If you are invested in index funds, most of the time you will not incur any fees for re-allocating from one fund to another you already own.

If you are investing in ETF’s, there are no fees if you are investing in commission-free ETF trading through a broker that offers it.

Some brokers, like Betterment, will even auto re-balance for you at no additional charge. And target date retirement funds auto re-balance too.

If you are instead invested in individual stocks and bonds, it is extremely costly to re-allocate funds, because each sale will typically require a trading fee through a broker. Working with a discount online broker can limit those fees, but they will still add up and take a significant chunk out of your assets. When re-allocating, it’s wise to invest in a manner that allows you to avoid trading fees altogether.

You also need to be aware of the bid-ask spread and make sure that you are not losing money by executing market orders.

When Should you Rebalance your Investments?

I don’t think there’s a perfect answer as to when you should rebalance, but you really have only two general options:

  1. when your allocations hit a certain percentage difference from the original allocation (i.e. one fund’s original allocation was 10% of your portfolio, now it is 15%).
  2. after a specified amount of time (i.e. every year)

If you’re not sure, here’s a general rule of thumb that you can modify off of: look every 12 months to see if any one investment has increased/decreased by more than 5% of your total original allocation. If so, rebalance.

You’ll also want to factor in capital gains taxes as well. Remember, positions held for over 1 year get favorable long-term capital gains tax rates. Positions held under a year are taxed as ordinary income.

See, that wasn’t so scary, was it?

Rebalancing Discussion:

  • Do you rebalance your portfolio?
  • How often do you check your allocation and after what % change would you rebalance?
  • Do you avoid re-allocation fees? How?

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