If you have ever heard the phrase “portfolio rebalancing” and wondered what it means, you’re not alone. But like other financial jargon, it may go in one ear and out the other. What is it exactly? And why is it important to understand?

Investing for a long-term goal can be likened to a ship sailing from New York City to London, a 3500-mile journey across the Atlantic Ocean. The voyage takes several days, and sailors must make numerous tactical shifts along the way due to changing weather and sea conditions. Without monitoring and adjusting its course, the boat is unlikely to reach its destination.

The same applies to investing. Let’s say a 35-year-old investor has the goal of retiring in 30 years and wants to grow their portfolio over that period. The investor can afford to assume a higher amount of risk and selects an initial allocation of 90% stocks and 10% bonds. Over that long timeframe, some of the assets may perform well and become a larger part of their portfolio, while others may lag and shrink from a percentage standpoint. Without periodic rebalancing, it’s possible that three years from now, the portfolio’s allocation will change to 70% stocks and 30% bonds. So, to rebalance, one would sell some bonds and buy more stocks to return the portfolio to its target allocation of 90% stocks and 10% bonds.

Investors and financial professionals often implement one of the following rebalancing methods.

Calendar Rebalancing

Calendar rebalancing is a simple approach that involves assessing the investment holdings at fixed timeframes and adjusting the portfolio back to its originally intended target allocation. Frequent reviews, like weekly, can become expensive from a transactional cost standpoint, and annual reviews can be too long for the portfolio to drift from its target allocation. So, most financial professionals believe monthly or quarterly portfolio rebalancing reviews to be the sweet spot. Another major advantage of calendar rebalancing is it’s significantly less time consuming for the investor than trigger rebalancing.

Trigger Rebalancing

A more common yet more demanding process is trigger rebalancing. With trigger rebalancing, the investor rebalances their portfolio whenever the assets drift from a certain target allocation, usually recommended by financial professionals to be 3% to 5%. Our 35-year-old investor with 90% stock exposure may have 40% in domestic blue-chip companies, 10% in domestic small-cap companies, 20% in developed international stocks, and 20% in emerging markets. When one of those asset classes drifts outside the desired threshold, the portfolio is rebalanced back to its targeted allocation. It’s important to note that trigger rebalancing may incur more trading during times of heavy market volatility, possibly leaving the investor with higher transaction costs and greater capital gains.

Before deciding on a rebalancing strategy for your portfolio, there is much to consider. How much time can you dedicate to this strategy? What are the potential transaction costs? When sold, nearly every investment in a taxable account generates some capital gains or losses. How will you account for this?

At Savant, we can help you align your finances with your long-term goals. More information about Savant’s evidence-based investment philosophy is available here.

Author Jonathon D. Merickel Portfolio Advisor

Jonathon has been involved in the financial services industry since 2002. He earned a bachelor of science degree from Syracuse University and an MBA from Le Moyne College.

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