An essential element of investment portfolio health is periodic rebalancing. This means evaluating your current mix of stocks, bonds, cash, and real estate investments, then selling and buying these various components to ensure that the actual proportions are the same as your desired proportions. For example, let’s say you want a portfolio that is 60% stocks and 40% bonds. If the stock market falls and you find yourself with 55% stocks and 45% bonds then you sell some bonds and buy some stocks to rebalance to the 60/40 mix. But how often should you rebalance and is there a best time of the year to rebalance? By using a little strategy in deciding when to rebalance, you can increase your overall investment returns.
Components of a diversified investment portfolio
The simplest way to think of portfolio diversification is stocks and bonds. As a general rule, when a person’s investment horizon is long, that person should have a higher percentage of stocks compared to bonds in their portfolio. On the other hand, when a person’s investment horizon is short, that person should have a higher percentage of bonds compared to stocks in their portfolio. Consequently, a 25-year old who is 40 years away from retirement should be primarily invested in stocks. A 65-year old who is ready to retire should have a higher percentage of bonds and a lower percentage of stocks in their investment portfolio.
In addition to one’s investment horizon, one’s willingness to take investment risk also affects the stock:bond ratio in a portfolio. For any given investment horizon, a higher risk portfolio will have a greater percentage of stocks than a lower risk portfolio. Because of this, a higher risk portfolio will have a greater chance of larger long-term returns but also has a greater chance of short-term losses. Investment anxiety is one way of determining investment risk. For example, if you lose sleep every time your 401(k) falls in value, then you should take a lower risk approach to investing. On the other hand, if the ups and downs of the stock market does not bother you, you can adopt a higher risk approach to investing. Life expectancy also affects investment portfolio risk. For example, a person in excellent health who anticipates living to an old age can afford to have a higher risk portfolio since their investment horizon is quite long, even at the age of retirement. Having a pension serves as a buffer in the event of short-term losses, therefore, a person with a sizable pension can afford to have a higher risk portfolio. If a person’s anticipated monthly income from their retirement portfolio is considerably higher than their monthly basic living expenses, then that person can afford to not take money out of retirement investments in years that the market has fallen and thus that person can also afford to have a higher risk investment portfolio.
By combining one’s investment horizon (i.e., age) with one’s willingness to accept investment risk, an individualized stock:bond ratio for their retirement portfolio can be created and might look something like this:
Merely looking at the ratio of stocks to bonds is an over-simplification of investment diversification. A better way to diversify is to subdivide stock and bond investments into U.S. versus foreign and to add a real estate component. This results in 6 categories of investment components:
- U.S. stocks
- Foreign stocks
- U.S. bonds
- Foreign bonds
- Real estate
Cash is any account that you can readily access for discretionary or emergency spending. Most people should have a minimum of 3 months and preferably 6 months of living expenses held in cash. Cash accounts include checking, savings, and money market accounts. Some people put certificates of deposit in the cash category but this can be risky. A 12-month CD results in money being tied up for 12 months before you can access it. This is fine for money you are planning to use for a down payment on a house you plan to buy a year from now but is inaccessible if you lose your job and need to buy groceries next month.
Stocks can be divided into those from U.S. companies and those from foreign companies. The difference between them can be confusing. For example, some foreign companies are traded on the New York Stock Exchange and many U.S. companies have a global presence by generating revenue from sales of products in other countries. Most mutual funds will specify whether their component stocks are from U.S. companies or foreign companies. So, for example, an S&P 500 index fund consists of 500 U.S. companies whereas a European index fund will consist of only European companies. However, the terminology can be confusing because a “global”, “international”, or “all-world” index fund may or may not include U.S. companies so it is important to understand the make-up of any given mutual fund.
Bonds can be divided into U.S. versus foreign but can also be divided into government bonds versus corporate bonds. As a general rule, corporate bonds have greater risk but higher potential returns than government bonds. Municipal government bonds are often tax-free whereas returns on U.S. treasury bonds are subject to tax.
Real estate can be an investment property that you personally own but most investors do not buy individual properties. Instead, they purchase REITs (real estate investment trusts) that are sort of like mutual funds for real estate. The REIT will own multiple properties (typically office buildings, hotels, apartment buildings, and shopping centers). The investor then buys shares of that REIT, just like they would buy shares of a stock mutual fund consisting of stocks from multiple companies.
Because the U.S. economy has historically out-performed most other nations’ economies and because the U.S. economy (and government) has also been more stable than most other nations’ economies, it is prudent to have a higher percentage of one’s investments in U.S. companies than in foreign companies. A typical tactic for stocks in a portfolio would be to maintain a ratio of 60% U.S. stocks and 40% foreign stocks. A typical tactic for bonds in a portfolio would be to maintain a ratio of 70% U.S. bonds and 30% foreign bonds. When it comes to risk and potential returns, REITs tend to fall in-between stocks and bonds. Therefore, it would be prudent to maintain a small percentage of one’s investment portfolio in real estate, for example, 5% of the total portfolio.
All of this can be complicated, so many people just purchase an “all-in-one” mutual fund that combines U.S. and foreign stocks and bonds in ratios depending on one’s investment horizon. These will sometimes be labeled as “Target Retirement 2045” for a person anticipating retiring in about the year 2045, for example. The following is the breakdown of Vanguard’s all-in-one mutual funds:
These all-in-one funds are a good choice for the investor who lacks the time, knowledge, or confidence to manage their own investment portfolio. An advantage of these funds is that the investment company does all of the rebalancing in order to maintain the desired ratio of stocks:bonds and then adjusts that desired ratio each year as a person gets older and their investment horizon shortens. However, these funds do not take into account the individual investor’s willingness or ability to assume risk and simply rely on investment horizon. Furthermore, the all-in-one funds generally do not include any real estate holdings, such as an REIT.
How often should you rebalance?
The largest investors on the planet are pension funds that can have billions or even trillions of dollars of invested assets. Although there is a lot of variation, most of pension funds rebalance monthly or quarterly. But for the individual investor, this is probably too frequent. For most of us, rebalancing once or twice a year is sufficient. The danger of rebalancing too frequently is that you can over-respond to short-term fluctuations in the market, resulting in a lot of buying and selling of investments. This can in turn result in a lot of investment transaction fees and a lot of capital gains. Those capital gains get taxed at either short-term or long-term capital gains tax rates. Short-term capital gains are on those investments that you sell less than 12 months after you purchased them; these are taxed at your regular federal income tax rate. Long-term capital gains are on those investments that you held for more than 12 months before selling and are taxed based on annual income levels at either 0% (for very low income investors), 20% (for very high income investors), or 15% (for most of us). As a general rule, your long-term capital gains tax rate will be lower than your short-term capital gains tax rate. The effect of this is that by rebalancing your non-retirement investment portfolio too frequently, you end up paying more in income taxes.
The danger of rebalancing too infrequently is that your investment portfolio can become too conservative (resulting in diminished long-term returns) or too aggressive (resulting in an excessively high-risk portfolio). Therefore, the timing of investment portfolio rebalancing is the intersection of patience and prudence.
I recommend doing a comprehensive rebalancing once a year and then doing an investment check-up every 3 or 6 months. During the check-up, if you find that your portfolio has become unexpectedly and significantly out of balance, then go ahead and rebalance at that time. What constitutes “significantly” out of balance is open for debate but I recommend using a 5% rule: if the percentage of one category of investments is off by more than 5 percentage points from your desired percentage, then it is significantly out of balance.
Take taxes into account
Investments can be grouped into three different categories: (1) regular investments, (2) tax-deferred retirement investments, and (3) Roth retirement investments. Regular investments are those that you purchase with your cash and you will pay capital gains taxes on them when you sell them. In addition, you will pay regular income tax on any interest or ordinary dividends that you earn from those investments each year. You will pay capital gains tax on any qualified dividends you get from an investment each year. If you own a stock for less than 60 days before the dividend date, then those dividends are considered ordinary and if you own a stock for more than 60 days before the dividend date, then those dividends are considered qualified. Tax-deferred investments include the 401(k), 403(b), 457, and traditional IRA. You pay regular income tax on any withdrawals when you are retired. There is no additional annual tax on interest and dividends earned from those investments but you will pay regular income tax on money generated from interest and dividends when you withdraw that money in retirement. Roth retirement investments include Roth IRAs, Roth 401(k)s, Roth 403(b)s, and Roth 457s. For these investments, you pay regular income tax in the year that you originally earn the money and deposit it in the Roth account; that money then grows tax-free until you take withdrawals in retirement. There is no tax on interest, dividends, or withdrawals.
The investment horizon differs for each of these three categories of investments. In general, Roth accounts have the longest investment horizon because it is prudent to wait until you turn 72 years old to begin withdrawals from Roth accounts. This is because required minimum distributions from tax-deferred retirement accounts (such as a 401k) begin at age 72 so it is usually to one’s advantage to begin to spend down those tax-deferred retirement accounts prior to age 72. Roth accounts are not subject to required minimum distributions. Regular investments typically have the shortest investment horizon because these are often used for non-retirement purchases, such as a house, college education, etc. Because of these differing investment horizons, it is wise to have stocks comprise most or all of one’s Roth accounts, a mix of stocks and bonds in one’s tax-deferred retirement accounts, and a higher percentage of bonds and cash in one’s regular investments.
The differences in how these different investments are taxed has implications for portfolio rebalancing. Most people will have their highest annual taxable income during their middle or late working years (i.e., in their 40’s, 50’s, and 60’s). This equates to having a higher marginal income tax rate during those years. Because you will be taxed at your regular income tax rate for any short-term capital gains, you will end up paying more in income taxes if you rebalance using regular investments during those peak earning years. Instead, it may be wise to rebalance using investments in your tax-deferred retirement account during those working years when you have a high income.
The exception to this is when you can take advantage of tax-loss harvesting. For example, say you find that your stock:bond ratio is 65:35 but your desired ratio is 60% stock and 40% bonds. So, you decide to sell some of your stock investments and buy some more bond investments. If one of your stocks has lost money since you originally purchased it, you can sell it for a loss. Tax-loss harvesting works by off-setting up to $3,000 in taxable capital gains each year with those losses. If your losses from sales of securities are greater than your capital gains from the sale of other securities for the year, then you can also use tax-loss harvesting to reduce your annual taxable income by up to $3,000. As a result, you can reduce your federal income tax in two ways: you have less income subject to tax and because of that your marginal income tax rate falls. But remember that tax-loss harvesting only applies to regular investments and not to the sale of securities within tax-deferred retirements or Roth accounts.
Taking all of these various factors into consideration, late December is an ideal time for most people to do a comprehensive investment rebalancing. By then, you should have a good idea of what your annual taxable income will be for that year and you can determine whether tax-loss harvesting will be beneficial. Early July is a good time to do a 6-month investment check-up. The following are considerations to take into account when rebalancing:
- What is the dividend calendar? Some funds pay dividends once a month but others pay dividends once a quarter or even less often. Many funds pay dividends in mid-December. Do not rebalance by selling an investment just before dividends are paid or you could lose out on those dividends.
- How long have you held an investment? If you rebalance by selling an investment that you have held for less than 12 months, you could end up paying the higher short-term capital gains tax rather than the lower long-term capital gains tax.
- Is your emergency fund sufficient? Every year, our basic living expenses increase due to inflation. But a new child adds considerably to those monthly expenses as does a new house with a larger mortgage or a new car loan. A marriage may increase or decrease the combined emergency fund needs of the two spouses, depending on individual circumstances. Reassess your current basic expenses to ensure that you have 3 to 6 months worth of those expenses held in cash.
- Do you have new non-retirement expenses in the future? Maybe you are planning on buying a more expensive new house in a year or two. Or maybe a new car. Or maybe you need a knee replacement surgery. If you need money for these types of expenses in the next 2-3 years, then the money should be in a safe investment such as a certificate of deposit or a money market. If you anticipate needing money for an expense 3-5 years from now, then some of that money could also be in bonds (but not in stocks).
- Have you lost money on some investment securities? If so, you may be able to take advantage of tax-loss harvesting.
- Has your investment horizon changed? Did you change your mind about when you or your spouse plan to retire, either earlier or later?
- Has your life expectancy changed? No one knows exactly how long they will live but in the past year, if you were diagnosed with cancer or developed congestive heart failure, then your life expectancy has likely decreased so you should adopt a lower risk investment strategy. On the other hand, if you successfully quit smoking, lost excess weight, and committed to a regular exercise program, then your life expectancy likely increased so you can adopt a higher risk investment strategy.
- Did your pension status change? If you change jobs so that you are no longer eligible for a pension, then you should adopt a lower risk investment portfolio. On the other hand, if you just got a job at a Veterans Administration hospital and will now be eligible for a federal pension, then you can adopt a higher risk investment portfolio.
- Did the total amount of your investments grow significantly? In retirement, the closer your annual income is to your annual basic living expenses, the less risk you can afford to take with your investments. This is because if the market falls, then you will have to deplete your retirement account faster than you anticipated in order to pay your living expenses. On the other hand, if your annual income in retirement is much higher than your basic living expenses, then you can reduce discretionary spending during years that the market falls and avoid depleting your retirement account. Consequently, if your retirement account has grown significantly in the past year, you may be able to adopt a higher risk investment portfolio. This is why the rich get richer – they can afford to.
Rebalancing is security
It is often said that money can’t buy you happiness. Although this is true, it can help you avoid unhappiness, which in not exactly the same thing. Annual or semi-annual investment portfolio rebalancing can increase your long-term investment returns. This can help to ensure that you have the money you need for a new home purchase, a wedding, or the life you dreamed about in retirement. But even more importantly, rebalancing forces you to critically evaluate your investment portfolio and this can give you confidence in your future and can give you a sense of control over your future. The real value of rebalancing is more than just the money.
June 16, 2023