A tough lesson for young automobile owners can come when they buy a car, drive it for months on end, never giving a thought to looking under the hood – only to run out of oil and ruin the engine. For the lack of an oil check, the car will no longer run.
Once you have a designed and implemented investment strategy, your portfolio is like that car: To keep everything running well, it’s a good idea to go in for periodic maintenance.
Rebalancing is the professions term used for performing tune-ups of your investments. Either on a calendar basis such as once a quarter or once a year, or as specific conditions change, you should check on your portfolio, see what has happened, and adjust the asset allocation and fund selections as needed. Financial Engines Advisor Center recommends you perform a personal quarterly review of your portfolio and bi-annual visits with your investment advisor.
Life has unlimited and unpredictable variables and investment markets do change, sometimes quickly. Even if you have bought high-quality mutual funds or other investments after diligent research, these should be monitored regularly to see if your portfolio needs rebalancing.
Changes in market prices of assets may be a reason for reviewing your accounts. We recommend you consult with a financial advisor to see if your portfolio continues to be structured correctly to meet your goals.
Other market changes that suggest a review of your account include increases in volatility that alter the risk profile of assets, higher inflation that requires an increase in returns to keep up, or new tax laws that may impact the returns on some assets. In addition, you should evaluate your portfolio if there are changes in fund management.
Changing your targets
Your portfolio review may also cause you to consider changing your asset allocation targets. Such a change in long-term strategy should be based on significant changes in your personal situation and not the short-term twists and turns of the market.
Among the personal changes that suggest a rethinking of asset allocation are changes in time horizon for your goals – for example, retirement is drawing near – or in family structure – such as getting married, getting divorced or having children. These changes may alter your level of tolerance for risk or your need for returns in a certain time frame.
In general, as retirement or other major goals get closer, you will want to reduce risk in your portfolio because you will need to draw out money in the near term.
In reviewing your portfolio, it is important not to change strategies on a whim or based on emotions. The market can play with an investor’s emotions, and if you alter your allocations with every turn in stock prices, you’re not any better off than an investor with no long-term strategy.
Rebalancing and taxes
In tax-deferred accounts such as an IRA or 401k, if you sell an investment that has appreciated in value in exchange for another, you won’t be taxed on the capital gain that you realize when you sell that investment. However, depending on the type of IRA, there may be tax consequences if you withdraw money from the account while rebalancing. It’s a good idea to contact a tax advisor for specific tax-related questions.
There are ways to minimize the amount of taxes that you will pay as a result of rebalancing, including:
- Holding an investment for a long period of time rather than a short period – Whenever possible, it is best to hold an investment for a long period of time before selling it. Realized gains from long-term investments are taxed at a lower rate than gains from short-term investments.
- Buying a mutual fund for your portfolio after a distribution occurs – Mutual funds make periodic distributions of income and capital gains, and if you are a shareholder as of the record date and therefore receive a distribution, then you are taxed on that distribution. It is therefore best to buy a mutual fund after the distribution.
What to do next
- First, be sure you have a well-designed asset allocation plan in place.
- Review your portfolio quarterly and schedule portfolio meetings with your investment advisor at least twice a year.
- Make sure reviewing your portfolio is a discipline applied to your plan to keep you on track with financial goals for the long run.